4.1.4 Terms Of Trade

Question 1

Terms of trade as a measurement

Answer 1

The terms of trade measures the rate of exchange of one product for another when two countries trade. It tells us the quantity of exports that need to be sold in order to purchase a given level of imports.

Question 2

Movement in the terms of trade

Answer 2

• Movement in the terms of trades is said to be ​favourable if the terms of trade increase as the country can buy more imports with the same level of exports. This is called an improvement in the terms of trade.
• It is ​unfavourable ​if they decrease, when export prices fall or import prices rise. This is called a ​deterioration.

Question 3

Calculation of terms of trade

Answer 3

It is measured in the form of an index because it is calculated from the weighted average of thousands of different export and import prices e.g. changes in the price of oil have larger impacts on the terms of trade than changes in the price of a Rolls Royce.

(Average export price index/Average import price index) x 100

Question 4

Factors influencing a country’s terms of trade

Answer 4

Value of exports and imports
- An improvement in the terms of trade will be caused by a rise in export prices or a fall in import prices
- A deterioration will be caused by a fall in export prices or a rise in import prices
Short-run
- Exchange rates, inflation and changes in demand/supply of imports or exports affect the terms of trade since these affect the relative prices of imports and exports
Long-run
- An improvement in productivity compared to a country’s main trading partners will decrease the terms of trade since export prices will fall relative to import prices. This can be caused by new technology, more efficient labour etc.
- Changing incomes affect the pattern of demand for goods/ services e.g. a rise in world income causes a rise in demand for tourism, so a country with a strong tourist industry, e.g. Spain, may see a rise in prices in that industry and hence an increase in their terms of trade

• In general, anything which affects the price of a country’s imports or exports
  will affect its terms of trade

Question 5

Impact of changes in a country’s terms of trade

Answer 5

• If PED of exports/imports is inelastic, a favourable movement in terms of trade would improve the current account on the balance of payments. If elastic, a favourable movement would worsen the current account
• Improvement in the terms of trade is likely to lead to a fall in GDP and a rise in unemployment, since if it is caused by a rise in export prices, exports will fall and if it is caused by a fall in import prices, imports will rise. Both of these cause a reduction in production within the country and so a fall in jobs and output a long term decline in the terms of trade suggests a long term decline in living standards as less imports can be bought.
• It is important to look at the cause of the change. If an improvement has occured due to increased demand for exports, then this will be beneficial for the country. If a deterioration is caused by an improvement in international competitiveness, this will also be beneficial. The ​export and import revenues are more important than the price alone. For an improvement to be beneficial, export revenues must increase.