Terms of Trade

Question 1

What is the terms of trade?

Answer 1

The relative price of a country’s exports, compared to its imports: the ratio of export prices to import prices.

Question 2

What is the formula for the terms of trade?

Answer 2

Index of terms of trade = (index of export prices ÷ index of import prices) x 100

Question 3

What are the 3 influences on the terms of trade?

Answer 3

1) Relative inflation rates.
2) Relative productivity rates.
3) Changes in exchange rates.

Question 4

How do relative inflation rates affect terms of trade?

Answer 4

If prices within a country rise, then the index of export prices is likely to rise, improving the terms of trade index. Vice-versa.

Question 5

How do relative productivity rates affect terms of trade?

Answer 5

Rising productivity leads to lower unit costs, worsening the terms of trade as export prices fall relative to imports. Vice-versa.

Question 6

How do changes in the exchange rate affect terms of trade?

Answer 6

A rise in the exchange rate will lead to a fall in the price of imports, improving the terms of trade. Vice-versa.

Question 7

Is a country better or worse off if their terms of trade rise?

Answer 7

Better off.

Question 8

What is the likely impact of an improvement of a country’s terms of trade on their balance of payments?

Answer 8

An improvement on the balance of payments, with the impact depending on elasticities of demand for imports and exports.

Question 9

What is the impact of an improvement of a country’s terms of trade on living standards (2)?

Answer 9

1) An improvement in the terms of trade, due to rising export prices, may lead to fewer exports and less demand for output from the export sector. This could cause unemployment and lower wages in the sector, reducing the workers living standards.
2) However, living standards may improve, as a country can import more for the same level of exports, due to the improved terms of trade.