3.4 terms of trade

Question 1

terms of trade (TOT)

Answer 1

an index that shows the value of a country’s average

export prices relatively to their average import prices.

Question 2

What are the consequences of changes in TOT in the short run?

Answer 2

• Shifts in the demand and supply
curve of imports and exports. When
the demand curves have shifted, the
price of imports and exports can
change, resulting in different TOT.

• Changes in global supply of key
inputs (production factors). When
the supply of these inputs change so
do their price. When the country
imports or exports these resources,
this will influence the average import
and export prices.

• Changes in relative inflation rates.
For example when the domestic
inflation increases relative to the
foreign inflation rate, export prices
will be higher and import prices will
be lower, resulting in an increase in
TOT.

• Changes in relative exchange rates.
For example when exchange rates
increase, the export price for foreign
countries will be higher and import
prices for the domestic country will
be lower. This results in an increase
in TOT.

Question 3

What are the consequences of changes in TOT in the long run?

Answer 3

• Changes in world income levels. For
example if income in the country
increases, there will be more demand
for imports so the import price will
increase thereby decreasing TOT.

• Changes in productivity within the
country. For example when the
country becomes more productive, it
can produce more efficiently and the
prices of domestic goods decrease.
This decreases the average export
price leading to a decrease in TOT.

• Technological developments. For
example when the country has gone
through technological advance, it
becomes more productive so it can
produce more efficiently and the
prices of domestic goods decrease.
This decreases the average export
price, leading to a decrease in TOT.

Question 4

What are the consequences of changes in TOT?

Answer 4

1. Effect on global distribution of income: Countries with greater TOT get more
   income at the expense of countries with low TOT in the long term because
   countries with high TOT pay relatively less for their imports and receive more
   money for their exports.
2. Effect on current account:
   • An improvement in TOT, caused by increase in demands for exports, will
   lead to an improved current account balance.
   • An improvement in TOT, caused by inflation, will lead to an improvement
   of the current account balance when demand for exports is inelastic.
3. Effect on the economy of developing countries: Developing countries have low TOT
   because price of primary commodities (which they export) has fallen over the past
   decades. Furthermore, the price elasticity of demand for primary products is low
   (inelastic) and the demand for these products hasn’t increased much to cover the
   loss in revenue due to the decrease in price.