8 Terms of Trade

Question 1

Q1: What is meant by the terms of trade?

Answer 1

A1: The terms of trade is an index that shows the value of a country’s average export prices relative to their average import prices. It indicates the level of imports that can be purchased with a given basket of exports.

Question 2

Q2: How is the terms of trade calculated?

Answer 2

A2: The terms of trade is calculated using the equation: Terms of Trade = Index of average export prices × 100 / Index of average import prices.

Question 3

Q3: How can the terms of trade worsen?

Answer 3

A3: The terms of trade can worsen if export prices fall or if import prices rise.

Question 4

Q4: How can the terms of trade improve?

Answer 4

A4: The terms of trade can improve if export prices rise or if import prices fall.

Question 5

Q5: What is the base value of the terms of trade index?

Answer 5

A5: The terms of trade index has a base value of 100 in the base year.

Question 6

Q6: How does an improvement in the terms of trade affect the index value?

Answer 6

A6: An improvement in the terms of trade would cause the index value to rise. For example, it may rise to 102, indicating that a basket of exports can buy 2% more imports compared to the base year.

Question 7

Q7: How does a worsening of the terms of trade affect the index value?

Answer 7

A7: A worsening of the terms of trade would cause the index value to fall. For example, it may fall to 98, indicating that a basket of exports can buy 2% less imports compared to the base year.

Question 8

Q8: What is one reason for a deterioration in the terms of trade?

Answer 8

A8: One reason for a deterioration in the terms of trade is a weak exchange rate. This occurs when the supply of the currency increases as the nation purchases more imports, leading to an increase in import prices and a decrease in export prices.

Question 9

Q9: How can an improvement in international competitiveness affect the terms of trade?

Answer 9

A9: An improvement in international competitiveness, resulting from factors such as a fall in relative inflation, a rise in productivity, or technological advancements, can worsen the terms of trade. This is because export prices will fall relative to import prices.

Question 10

Q10: What is another reason for a deterioration in the terms of trade?

Answer 10

A10: Another reason for a deterioration in the terms of trade is lower demand for a nation’s exports. This can occur due to falling incomes abroad, particularly in major trading partners experiencing recession. As a result, export prices will fall relative to import prices.

Question 11

Q11: How can the Prebisch-Singer hypothesis explain a deterioration in the terms of trade?

Answer 11

A11: The Prebisch-Singer hypothesis suggests that if a country specializes in the production and export of primary commodities while importing capital or manufactured goods, a rise in world incomes can worsen its terms of trade. This is because demand and prices for manufactured goods rise faster than for primary commodities, negatively impacting the terms of trade.

Question 12

Q1: What is one reason for an improvement in the terms of trade?

Answer 12

A strong exchange rate. This could be because demand for the currency is increasing as the nation is selling more exports. As a consequence, the price of imports decreases while the price of exports increases, improving the terms of trade, meaning more imports can be bought with the revenues generated from the selling of the same basket of exports.

Question 13

Q2: What could lead to a worsening in international competitiveness, resulting in an improvement in the terms of trade?

Answer 13

A worsening in international competitiveness. This could be because of a rise in relative inflation, a fall in productivity, or capital depreciation through poor investment. As a consequence, export prices will rise relative to import prices, improving the terms of trade.

Question 14

Q3: What could cause a higher demand for a nation’s exports, leading to an improvement in the terms of trade?

Answer 14

Higher demand for a nation’s exports. This could be because of rising incomes abroad as economies of major trading partners boom. As a consequence, export prices will rise relative to import prices, improving the terms of trade.

Question 15

Q1: How can a fall in the terms of trade impact aggregate demand in an economy dependent on primary commodities?

Answer 15

A fall in the terms of trade caused by a fall in export prices for a country dependent on primary commodities could reduce aggregate demand in the economy. This is because the demand for primary commodities is price inelastic. Therefore, as prices fall, so do the revenues generated from their export for developing countries. As a consequence, economic growth will fall in developing countries, reducing incomes and living standards for individuals via a fall in GDP or GNI/capita.

Question 16

Q2: What happens to developing countries when they have to sell more and more exports to maintain the same amount of imports?

Answer 16

Developing countries have to sell more and more exports in order to buy the same amount of imports. This is because demand for imports tends to be price inelastic, for example, capital imports which are necessary for production. Consequently, incomes and profits are lower with more money spent on the same level of imports, harming economic development with less income available to spend on life-sustaining goods and services. In response, developing countries tend to increase the supply of their commodities, but this pushes commodity prices down even more, worsening the problem.

Question 17

Q3: How can a fall in the terms of trade affect the government budget position?

Answer 17

A fall in the terms of trade could significantly worsen the government budget position. This is because as export prices fall, for example, and demand for these exports is price inelastic, revenues generated by these exports will decrease, reducing the tax revenue collected by the government from corporation tax, income tax, and expenditure taxes like VAT as the economy slows. As a consequence, the government will have less revenue to spend on education, healthcare, and infrastructure, all crucial for the long-run performance and growth of the economy.

Question 18

Q4: What are the implications of a fall in the terms of trade for the indebtedness of a developing nation?

Answer 18

A developing nation is likely to experience higher levels of indebtedness. This is because if export prices are falling, export revenue will fall too, making it harder to service existing debt. Indeed, in extreme cases, this leads to countries having to increase their borrowing and increasing their levels of indebtedness to purchase capital imports. As a consequence, more money is diverted into debt repayment and debt interest payment instead of promoting growth and development. Furthermore, in order to pay back their debts, many countries increase their output of commodities in which they have a comparative advantage. This increases supply, drives prices down, and worsens the issue.

Question 19

Q1: evaluation: Is a terms of trade improvement good for an economy? What does it depend on?

Answer 19

A1: Whether a terms of trade improvement is good for an economy depends on the cause. It depends on factors such as higher export demand and the price elasticity of demand for exports.

Question 20

Q2: How does higher export demand, improving the terms of trade via higher export prices, benefit an economy?

Answer 20

A2: Higher export demand, improving the terms of trade via higher export prices, benefits an economy as export revenues will rise, improving the current account position and increasing aggregate demand (AD).

Question 21

Q3: How does the price elasticity of demand for exports affect the benefits of a worsening of international competitiveness?

Answer 21

A3: The price elasticity of demand for exports is the determining factor in whether a worsening of international competitiveness, which improves the terms of trade via an increase in export prices, benefits an economy. If the demand for exports is price inelastic, as export prices increase, the quantity demanded for exports decreases but proportionately less than the price increase. This leads to an increase in export revenues, improving the current account position and boosting AD.

Question 22

Q4: How does the availability of substitutes impact the elasticity of demand for a country’s exports?

Answer 22

A4: The growing force of globalization means that there are many substitutes available for an importing country. Therefore, demand for a country’s exports will be more elastic over time, resulting in a more than proportionate decrease in quantity demanded for exports compared to the price rise. This worsens the current account position and AD.

Question 23

Q5: What determines whether a strong exchange rate, which improves the terms of trade, will benefit an economy?

Answer 23

A5: Whether a strong exchange rate, which improves the terms of trade via an increase in export prices and a reduction in import prices, will benefit an economy depends on the price elasticity of demand (PED) for both exports and imports. If the PED of exports is price inelastic, export revenues increase despite the price increase. Similarly, if the PED of imports is price inelastic, import expenditure decreases despite the price decrease. These effects improve the current account position and boost AD. The opposite is true if the PED of exports and imports is price elastic.

Question 24

Q1: Is a terms of trade deterioration always bad for an economy?

Answer 24

Evaluation: No, it depends on the cause. If a terms of trade deterioration is due to lower export demand, resulting in lower export prices, it will be bad for an economy as export revenues will fall, worsening the current account position and decreasing aggregate demand (AD).

Question 25

Q2: What determines whether better international competitiveness, which worsens the terms of trade, benefits an economy?

Answer 25

Evaluation: The price elasticity of demand for exports is the determining factor. If the demand for exports is price elastic, as the price of exports decreases, demand for exports will increase proportionately more than the price decrease. Thus, export revenues increase, improving the current account position and boosting AD. Due to the growing force of globalization, this is likely to be the case in the real world, making it beneficial for an economy.

Question 26

Q3: Does a weak exchange rate, which worsens the terms of trade, always benefit an economy?

Answer 26

Evaluation: No, it depends on the price elasticity of demand (PED) for both exports and imports. Regardless of the PED for exports (PEDx), export revenues in domestic currency terms will always rise as export prices fall. However, if the demand for imports is price elastic, as the price of imports increases, demand for imports will fall proportionately more than the price increase. This leads to a decrease in import expenditure, improving the current account position and boosting AD. The opposite is true if the PED of imports is significantly price inelastic, where increases in import expenditure could offset increases in export revenue. This occurs when the Marshall-Lerner condition is not satisfied.