4.1.4: Terms of Trade

Question 1

What are terms of trade?

Answer 1

• The ratio between a country’s export prices and its import prices
• It is a measure of a countries relative competitiveness

Question 2

What is the formula for terms of trade?

Answer 2

• (Index of Average Export Prices/ Index of Average Import Prices) x 100

Question 3

What are improvements in terms of trade?

Answer 3

• If terms of trade increase as the country can buy more imports with the same level of exports (favourable movement)

Question 4

What is deterioration in terms of trade?

Answer 4

• if terms of trade decrease, when export prices fall or import prices rises ( unfavourable movement)

Question 5

What factors influence a country’s terms of trade?

Answer 5

• In the short run, exchange rates, inflation and changes in demand/ supply of imports or exports.
• In the long run, an improvement in productivity and changing incomes

Question 6

How does an improvement in productivity cause changes in terms of trade?

Answer 6

• 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 occur due to new technology, more efficient labour etc

Question 7

How do changes in income cause changes in terms of trade?

Answer 7

• This affects the pattern of demand for goods and services.
• The Prebisch-Singer hypothesis suggests the long run price of primary goods declines in proportion to manufactured goods, which means those dependent on primary exports will see a fall in their terms of trade.
• As income rises, the demand for imports may increase, which could drive up the price of imports. If the export prices remain relatively unchanged, the terms of trade could worsen

Question 8

How changes in terms of trade affect balance of payments?

Answer 8

• If PED of exports and imports is inelastic, a favourable movement in terms of trade would improve the current account on the balance of payments.
• If PED if elastic, a favourable movement would worsen the current account.

Question 9

How do changes in terms of trade affect GDP and unemployment?

Answer 9

• An improvement in terms of trade is likely to lead to a fall in GDP and a rise in unemployment, as if it is
• : caused by a rise in export prices, exports will fall
• : caused by a fall in import prices, imports will rise

Question 10

How do changes in terms of trade affect living standards?

Answer 10

• A long term decline in the terms of trade suggests a long term decline in living standards as less imports can be bought.

Question 11

When are improvements and deterioration of terms of trade beneficial to an economy?

Answer 11

• if an improvement has occured due to increased demand for exports
• if a detoriation is caused by an improvment in international competitiveness
• When exports revenues increase, improvements are beneficial