Chapter 8 - Terms of Trade Flashcards
What is the ‘Terms of Trade’?
An index that shows the value of a country’s average export prices realtive to their average import price.
It is an indicator of the level of imports a given basket of exports can buy. It is calculated using:
Terms of trade = (Index of average export prices / index of average import prices) X 100
What does a rise in the terms of trade index from 100 to 102 mean?
What about a fall from 100 to 98?
It means a basket of exports can buy 2% more imports than in the base year. Export prices rise realtive to import prices OR import prices fall relative to export prices
Meaning a basket of exports can buy 2% less imports than in the base year. Import prices rise realtive to exports, OR export prices fall relative to import prices
What are some reasons for a deterioration on the terms of trade? 4
1) A weak exchange rate
The price of imporets increases while the price of exports decreases, worsening the terms of trade meaning more exports will need to be sold to purchase the sdame amount of imports
2) An imporvement in international competitiveness
For example cuz of a fall in relative inflation, a rise in productivity or technological advancements -> export prices fall realtive to importy prices -> worsening terms of trade
3) Lower demand for a naion’s exports and/or higher demand for imports
Export prices fall relative to import prices, worsening terms of trade
4) Prebisch-Singer hypothesis - If world incomes are rising but a country is specialising in the production and export of primary commodities whilst importing capital or manufactured good.
This is because demand for primary commodities is income inelastic whilst demand for manufactured goods is income elastic -> as a consequence, as world incomes rise, demand for and therefore price of manufactured goods rise FASTER THAN the demand and price for primary commodities -> worsening terms of trade for such a country
What are some reasons for an imporvement in the Terms of Trade? 3
1) A strong exchange rate
Price of imports decreases whilst price of exports rises -> improving terms of trade as more imports can be bought with the revenue generated from the same basket of exports
2) Worsening international competitiveness
Export prices rise realtive to import prices -> improving terms of trade
3) Higher demand for a nation’s exports and/or lower demand for imports
Due to changes in incomes abroad or at home -> export prices rise relative import prices -> improving the terms of trade
What are the impacts of a fall in terms of trade for coutries that are dependant on the export of primary commodities caused by low export prices?
1) Reduced aggregate demand in economy
Demand for primary commodities is price inelastic -> therefore as prices fall so does revenue generated from exports -> reducing (x-m) -> reducing AD -> reducing growth -> reducing incomes and living standards VIA a fall in GDP
2) Developing countries have to sell more exports in order to buy the same amount of imports
As a result incomes and profits are lower with more money spent on same levels of imports -> harming economic development -> less income available to spend on life sustaining goods and services -> AS A RESPONSE developing countries tend to increase supply of their commodities but this just pushes price down more
3) A fall in terms of trade can worsen government budget position
Export prices rise -> price inelastic -> revenues from exports fall -> reducing tax revenue collected by govs from cooporation tax, income tax and taxes like VAT -> Gov has less revenue to spend on education, healthcare and infra -> hampering long run performance and economic growth
4) Experience higher levels of indebtedness
If export prices are falling -> export revenues falling -> harder to service existing debt -> countries may have to increase borrowing to pruchase capital imports -> more money diverted into debt servicing -> opporuntity cost
Is a terms of trade IMPORVEMENT good for an economy? Evaluation (3)
It depends on the cause
1) If caused by higher export demand = improving terms of trade via higher export prices -> beneficial for economy as CA position imporves -> boosting AD
2) If caused by a worsening of international competiiveness, then it depends on elastcity of demand of exports
Worsening of international competitiveness -> export prices rise -> if they are PED elastic then demand will fall greter than rise in price -> reduction in revenue -> worsening (x-m) and CA -> reducing AD
If PED inelastic -> then demadn will fall proportionally less than increase in price -> boosting export revenue -> improving CA position -> boosting AD and growth
3) If caused by a strong exchange rate, it depends on both PED of imports and exports
IF EXPORT ARE PED INELASTIC -> Strong exchange rate -> SPICED -> export prices rise -> demand decreases proportionatly less -> export revenues fall by SMALL amount
IF IMPORTS ARE PED INELASTIC -> Strong exchange rate -> price of imports decreases -> demand for imports rises proportionatly less than price decreas -> import expenditure will decrease
For a strong exchang rate to improve economy, demand elasticties will need to be at a point where import expenditure falls by more than export revenue for CA position to improve
Is a terms of trade DETERIORATION bad for an economy? EVALUATION 3
It depends on the cause
1) If caused by lower export demand
Worsening terms oif trade via lower export prices ->export revenues will fall -> worsenign CA position and reducing AD
2) If caused by better inernational competitiveness, it depends on the price elasticity of demand for exports
If price elastic = improvement in international competitiveness -> lower price of exports -> proportionatlly greater increase in demand -> increasing export revenue -> improving CA position -> BENEFICIAL
If price inelastic = improvement in international competitiveness -> lower price of exports -> proportionatlly smaller increase in demand -> net decrease in export revenue -> NOT GOOD
3) If caused by a weak exchange rate, depends on PED of imports and exports
There must be a strong demand repsonse to cheaper exports for export revenue to rise and a strong demand response to more expensive imports for import revenue to fall -> this would result in an improvement in CA positoin
(Marshall-Lenner condition)
