4.1.4 Terms of trade – Edexcel Economics A notes

Contents

How to calculate the terms of trade

Here’s a formula to calculate a country’s terms of trade (ToT):

Why does the terms of trade matter? A change in terms of trade has mixed consequences for the domestic economy.

Specifically, the higher the terms of trade number:

• The more imports a country can buy for each export it sells.
• The greater the country’s net exports (assuming given quantities of exports and imports).
• The less price competitive the country’s exports are relative to other countries.

Which factors influence a country’s terms of trade?

When thinking about what influences terms of trade (ToT), think about which factors affect export or import prices.

Determinants of the terms of trade include:

• Changes in relative inflation rates.
  • Higher inflation in the UK relative to other countries would mean export prices rise more quickly than import prices.
  • This results in the value of ToT increasing.
• Changes in relative productivity.
  • Poor productivity performance in the UK relative to competitor economies could lead to higher inflation in the UK relative to other countries.
  • Again this would result in the value of ToT falling.
• Changes in commodity prices.
  • A fall in commodity prices could reduce export prices for commodity exporters, reducing ToT.
  • Meanwhile countries importing commodities would see falling import prices, leading to a higher ToT.
  • The Prebisch-Singer hypothesis suggests that as the global economy grows, prices of primary products will rise at a slower rate over time compared to prices of manufactured goods and services. This would suggest a falling ToT for commodity exporters over time.
• Changes in the exchange rate.
  • A depreciation in the exchange rate makes imports dearer. This lowers the ToT
  • Note exchange rate changes could be caused by several factors. This includes:
    • Changes in relative interest rates.
    • Other reasons for changes in demand for exports and imports e.g. the removal of travel restrictions (such as visa rules or Covid-19 travel restrictions) leading to higher demand for travel.
    • Reasons for changes in investment inflows or outflows.
    • Or other causes of changes in exchange rates.
• Other factors include:
  • Tariffs for large importers like the US, who can use their buying power to lower import prices relative to export prices.
  • Changes to the pattern of global demand. For example, consumers switching to healthy food would boost demand and prices for healthy food. This increases ToT for exporters of fruits and vegetables and reduces ToT for fruit and vegetable importers.
  • Natural disasters and climate change could lead to poor harvests, reducing supply and increasing prices of crops. This would again increase ToT for crop exporters and lower ToT for crop importers.

What are the impacts of a change in the country’s terms of trade?

A change in the terms of trade can have a positive or negative effect on the domestic economy. This depends on the price elasticities of demand for exports and imports.

• Higher net exports
  • An increase in terms of trade means export prices are higher relative to import prices.
  • Provided the quantities of exports and imports do not change much, an increase in ToT should increase the value of net exports. This is because export revenue increases relative to import spending.
  • So aggregate demand rises (as net exports are a component of AD, AD = C + I + G + X – M).
  • So the economic growth rate rises. As demand for labour is derived from the demand for goods and services, higher AD leads to higher employment.
• Lower net exports
  • However, an increase in terms of trade could suggest exports are becoming less price-competitive relative to imports.
  • If export prices increase, this could reduce export demand. Export revenues could fall if export demand is price-elastic.
  • If import prices decrease, this increases import demand. Import expenditure could rise if import demand is price-elastic.
    • Exam tip: The price elasticities of demand for exports or imports is a key evaluation point. It determines whether net exports rise or fall.
  • This reduces net exports, so aggregate demand falls (AD = C + I + G + X – M).
  • So the economic growth rate falls and employment decreases.
• Further effects on AD and investment. For example following a fall in export revenue, there can be:
  • This includes a negative multiplier effect. The fall in net exports reduces profits for exporters. So exporting companies have reduced funds available to pay workers. As a result, workers’ disposable income falls, leading to lower consumption and a further fall in AD.
  • Lower investment as exporting firms have reduced funds available for investment. This can reduce both AD (as investment is a component of AD), but it could also reduce the quality and quantity of factors of production, with capital wearing off and not being replaced.

Developing countries and terms of trade

Some developing countries rely on exporting primary products such as oil, rare metals and agricultural goods.

These countries are particularly vulnerable to “terms of trade shocks“.

Primary products often have highly price-inelastic demand. This means that a fall in export prices is likely to reduce export revenue significantly.

Because of this, primary product dependency and volatile commodity prices can be barriers to development and growth.

An example of this is arabica coffee in Ethiopia. A fall in global coffee prices in 1986-87 led to a 40% fall in Ethiopia’s terms of trade. This led to real income in Ethiopia falling by 6% (source: IMF).

Practice question on terms of trade

This question contains a mini extract, followed by a practice question.

Venezuela’s terms of trade fell by 42.5% from 2014 to 2015. Over 90% of export revenues for Venezuela come from oil, but global oil prices fell by over 70% from 2014 to 2015. Meanwhile the Venezuelan government has printed money and devalued its currency on several occasions, with the annual rate of inflation running at 75.8% as of January 2015. (Sources: Trading Economics, The Global Economy, miscellaneous others).

Question: Evaluate two causes of changes in Venezuela’s terms of trade. (15 marks)

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