4.1.4 Terms Of Trade

Question 1

What is Terms of Trade

Answer 1

The terms of trade (ToT) measures the relative prices of a country’s exports compared to the cost (prices) of imported goods and services.
• Terms of trade can be interpreted in words as the amount of imported goods and services that an economy can purchase per unit of exported goods and services.

Question 2

How do you calculate terms of trade?

Answer 2

• (Price index for EXPORTS of goods and services) divided by (Price index for imports of goods and services) x100

Question 3

What are some factors influencing a country’s terms of trade?

Answer 3

1. Globalization and Trade Composition: Globalization has impacted the prices of goods and services differently. Countries that export services and import manufactured goods have seen improvements in their terms of trade due to the relatively lower decrease in service prices compared to manufactured goods.
2. Price Elasticity of Demand: The elasticity of demand for exports and imports plays a critical role. Countries with inelastic demand for their exports can demand higher prices, improving their terms of trade. Conversely, countries reliant on importing manufactured goods while exporting primary goods may experience worsening terms of trade.
3. Exchange Rates and Inflation: An appreciation in a country’s exchange rate can improve its terms of trade by increasing export prices and decreasing import prices. Additionally, relative inflation rates impact competitiveness; higher inflation makes exports more expensive, potentially worsening terms of trade if demand is elastic.
4. Productivity and Protectionism: Higher productivity can lower export costs, potentially deteriorating terms of trade as fewer imports are obtained per unit of export. Protectionist measures can improve terms of trade by restricting imports, provided there is no retaliation from other countries.
5. The Prebisch-Singer hypothesis suggests that over time, due to falling commodity prices in relation to manufactured goods, the terms of trade for developing countries has fallen. Due to globalisation reducing the price of manufactured goods, this effect has been offset slightly.

Question 4

What are some impacts of changes in a countries terms of trade?

Answer 4

Improving terms of trade mean the economy can import more goods for each unit of export.
This can help reduce the effects of cost-push inflation, since import prices are falling relative to export prices. It could also help improve standards of living for consumers in the country.
However, it can mean that the balance of payments worsens, since there are fewer exports and more imports.

Worsening terms of trade means that for every import, the country has to export more. It could make the price of new technology more expensive, which might limit productivity.
It could lead to a fall in living standards, and because it is more difficult to earn foreign currency, it becomes harder to pay foreign debt.