4.1 - Terms of trade Flashcards
International economics
How do you calculate terms of trade?
Terms of trade =
(Index of average export prices / index of average import prices) X 100
What is the terms of trade ?
measure of the ratio of the index of a country’s export prices to the index of a country’s import prices.
tells you what value of exports you need to ‘pay for’ a given value of imports
stronger terms of trade imply greater competitiveness
What does a higher value terms of trade and a lower value terms of trade indicate?
- higher value terms of trade = export prices are rising at a higher rate than import prices/ import prices decreasing at a lower rare than export prices = improvement in terms of trade
- falling value terms of trade = import prices are rising at a faster rate than export prices/ export prices are decreasing at a faster rate than import prices = worsening terms of trade
Why is an increasing terms of trade value an improvement in the terms of trade?
- means a country can buy more imports for a given amount of exports sold abroad
(> a unit of exports sold abroad can buy more imports)
Why is a falling terms of trade value a worsening of the terms of trade?
- means a country can’t buy as many imports for a given amount of exports sold
(> a unit of exports sold can buy less imports)
What factors influence a country’s terms of trade?
1) Relative inflation rates: > Inflation increases the price of goods/services within a country.
> This means that their price is now more expensive to the rest of the world.
> If the exports are price inelastic in demand this will improve the terms of trade, if elastic then it is likely to worsen the terms of trade
2) Relative productivity rates:
> Continuous improvements in productivity can lower costs and these can be passed on in the form of lower prices.
> Lower prices for export products will mean that the terms of trade will deteriorate i.e. fewer imports can be bought with one unit of exports
3) Changes in exchange rates:
> Exchange rates constantly change the price of exports and imports.
> If prices change then the terms of trade between the two countries change.
> Higher currency value (appreciation) means higher export prices and lower import prices - improvement in TOT
> Lower currency value (depreciation) means lower export prices and higher import prices - worsened TOT
What are some impacts of changes in the terms of trade?
- Changes to the current account balance in the Balance of Payments
- Changes to national output (GDP)
- Changes to unemployment levels
- Changes to the level of international competitiveness
- Changes to disposable income
- Changes to standards of living
Explain how an improvement in the TOT can lead to an increase in GDP …
> improvement in TOT could lead to an increase in GDP
firms earn more export revenue (if their G/S is price inelastic)
firms decrease costs of production (cheaper imports - eg: raw materials)
firms profits increase - invest more / hire more workers / increase wages
increased Investment + consumption cause increase in aggregate demand and GDP
However only if the g/s being exported are price inelastic
Explain how an improvement in the terms of trade may lead to a current account deficit …
> improvement in TOT could lead to fewer exports and more imports (if they are price elastic)
current account deficit
Explain the likely economic outcomes of a deteriorating terms of trade caused by a decrease in the price of exports, assuming the exports are PED elastic …
- If PED of exports is elastic then the increase in quantity demanded will be more than the decrease in price and the economy will benefit
> Output increases
> Unemployment decreases
> Standard of living improves
Explain the likely economic outcomes of a deteriorating terms of trade caused by an increase in the price of imports, assuming the imports are PED elastic …
- Where demand for imports is price inelastic, consumers would demand the goods in similar proportions and thus spend significantly more on imports
> Domestic output unlikely to fall
> Imports will decrease slightly
> Less disposable income so worse standard of living
Explain the likely economic outcomes of an improving terms of trade caused by an increase in the price of exports, assuming the exports are PED inelastic …
- If PED of exports is inelastic then the reduction in quantity demanded will be less than the increase in price and the economy will benefit
> Output increases
> Unemployment decreases
> Standard of living improves
Explain the likely economic outcomes of an improving terms of trade caused by a decrease in the price of imports, assuming the imports are PED elastic …
- If PED of imports is elastic (necessity) then the increase in quantity demanded will be more than the decrease in price and the economy will spend more on imports
> More disposable income
> Standard of living improves
> Increase in consumer choice
> Domestic output may fall as foreign consumption increases
