4.1.4 Terms Of Trade Flashcards
What are terms of trade?
An index that shows the value of a country’s average export prices relative to their average import prices.
What is the equation for terms of trade?
Index of average export prices / Index of average import prices x 100.
Why can terms of trade worsen?
- Worsen: if export prices fall or if import prices rise.
Why can terms of trade improve?
- Improve: if export prices rise or if import prices fall.
What are reasons for deterioration in the terms of trade?
- A weak exchange rate.
- An improvement in international competitiveness.
- Lower demand for a nation’s exports and/or higher supply of imports.
- If world incomes are rising but the country is specializing in production and exports of primary commodities whilst importing capital or manufacturing goods.
What is a weak exchange rate?
- Could be because supply of currency is increasing as the nation is purchasing more imports.
- As a result, the price of imports increases and the price of exports decreases, worsening terms of trade.
What does an improvement in international competitiveness mean?
- Could be due to a fall in relative inflation, rise in productivity, or technological advancements in the economy through greater investment.
- As a result, export prices will fall relative to import prices, worsening terms of trade.
What does lower demand for a nation’s exports and/or higher supply of imports indicate?
- Lower demand could be due to falling incomes abroad as economies of major trading partners are in greater recession.
- Higher supply could be due to good weather abroad.
- As a result, export prices fall relative to import prices, worsening terms of trade.
What happens if world incomes are rising but a country specializes in primary commodities?
- Primary commodities are income inelastic, while manufactured goods are income elastic.
- As a result, as world incomes rise, demand and prices for manufactured goods rise faster than for primary commodities, worsening terms of trade (Prebisch-Singer hypothesis).
What are reasons for improvement in terms of trade?
- A strong exchange rate.
- Worsening international competitiveness.
- Higher demand for a nation’s exports and/or lower supply of imports.
What is a strong exchange rate?
- Could be because demand for currency is increasing as the nation is selling more exports.
- As a result, the price of imports decreases and the price of exports increases, improving terms of trade.
What does worsening international competitiveness mean?
- Could be due to a rise in relative inflation, fall in productivity, or capital depreciation due to reduced investment.
- As a result, export prices will rise relative to import prices, improving terms of trade.
What does higher demand for a nation’s exports and/or lower supply of imports indicate?
- Higher demand for exports could be due to rising incomes abroad as economies of major trading partners boom.
- Lower supply of imports could be due to bad weather abroad.
- As a result, export prices rise relative to import prices, improving terms of trade.
What is the impact of a fall in terms of trade for countries dependent on the export of primary commodities?
- Reduce aggregate demand (AD) in the economy.
- Developing countries have to sell more exports to buy the same quantity of imports.
- Worsen government budget.
- Higher levels of indebtedness.
How does a fall in terms of trade reduce AD in the economy?
- Demand for primary commodities is price inelastic, so prices and revenue generated from their export fall.
- As a result, economic growth will fall in developing countries, reducing incomes and living standards via a fall in GDP.
What happens when developing countries have to sell more exports to buy the same quantity of imports?
- Demand for imports tends to be price inelastic.
- As a result, incomes and profits are lower with more money spent on the same level of imports, harming economic development.
What does worsening of government budget mean?
- Demand for exports is price inelastic, so as export prices fall, revenue generated from them will fall.
- As a result, the government has reduced revenue for spending on education, healthcare, and infrastructure.
What are high levels of indebtedness?
- If export prices fall, export revenue falls, making it harder to service existing debt.
- As a result, countries have to increase borrowing and indebtedness to purchase capital imports.
What is the effect of higher export prices on terms of trade?
Higher export prices can benefit an economy if demand for exports is price inelastic, leading to increased export revenues and improved current account balance.
What happens if demand for exports is price elastic when export prices rise?
Export demand will fall more than the price increase, reducing export revenue and worsening the current account.
Why does PED of exports determine the effects of a terms of trade improvement?
- It determines whether higher export prices lead to increased or decreased revenue.
- If inelastic demand, revenue rises; if elastic demand, revenue falls.
How does globalization affect the PED for exports?
- Globalization increases the availability of substitutes, making demand for a country’s exports more elastic.
How does a strong exchange rate influence terms of trade improvement?
- A strong exchange rate increases export prices and lowers import prices, depending on PED for exports and imports.
What needs to happen for a strong exchange rate to benefit an economy?
- If PED of exports is inelastic and PED of imports is elastic, export revenues rise and import expenditure falls, improving the current account position.
