Definitions

 

1. Terms of trade is an index that shows the value of a country’s average export prices relative to their average import prices.

 

Equation

 

Terms of Trade (TOT) = Weighted index of the average export prices X 100

Weighted index of the average import prices

 

Causes of changes in a country’s terms of trade in the short run

 

1.      Changes in the conditions of demand and supply

• If demand for exports changes → Price of exports also changes.
• Prices of competitive good in other countries may change, affecting the competitiveness of the exports.
• Incomes in the importing countries may change, affecting the demand for imports.
• Consumer tastes may change for products that the country exports.
• If certain countries experience an increase supply of a certain product, price will fall.
• Change on the TOT depends on the importance of overall exports of the good.

2.      Changes in relative inflation rates

• Inflation rate in one country is higher than in another → Export prices will rise.
• Although this improves TOT, the country’s exports will start to be less competitive.

3.      Changes in exchange rates

• Change in the value of a currency → Change in price of exports relative to imports.
• May be done through market forces or as a result of government intervention in the foreign exchange market.

Causes of changes in a country’ terms of trade in the long run

 

1. Income changes

• Rising incomes → Increase in demand for secondary and tertiary products → XED is elastic.
• TOT of developed countries improve relatively to TOT of developing countries, where XED is inelastic.

2. Long-run improvements in productivity within a country.

• Countries will experience a gradual deterioration of the TOT because prices don’t rise significantly in their country.
• Exports will become more competitive in the international markets.
• If demand is elastic, the result could be positive.

3. Long-run improvements in technology within a country.

• Lead to lower production costs → Increase supply → Lower prices.
• Countries will experience a gradual deterioration of the TOT because prices don’t rise significantly in their country.
• Exports are more competitive and if PED of exports is elastic, the balance of trade should improve.

 

Effect of Terms of Trade for price elasticity of demand for exports.

• PED_exports = % change in demand for exports           

% change in average price for exports

• If demand for exports is elastic → Change in price → Greater proportional change in the demand for the exported products → Increase in export revenues
• Good for countries where export prices are falling.
• Many commodities, which are exports, have inelastic demand in the long run.

 

Effects of Terms of Trade for price elasticity of demand for imports.

• PED_iimports = % change in demand for imports           

% change in average price for imports

• If demand for imports is elastic → Change in price → Greater proportional change in the demand for the imported products → Increase in import expenditure
• Good for countries where import prices are falling.
• Many commodities, which are imports, have inelastic demand in the long run.

Downward trend in commodity prices for developing countries

1. There has been a substantial increase in the supply of commodities, mostly caused by improvements in technology, which allowed discovery for more minerals and efficient way of mineral extraction.
2. Discovery of synthetic replacements for natural commodities resulted in slow increase in demand for the natural commodities.
3. The demand for commodities hasn’t changed greatly because the income for developed countries is income inelastic. However, increase in income → increase in prices of manufactured goods and services, which are more income elastic.
4. Agricultural policies have had a damaging effect on the world agricultural markets, which lead to high prices and overproduction by domestic producers, which lead to a fall in agricultural prices worldwide.
5. Many products have become smaller due to technological advancements. This resulted in a less demand for commodities that were used to make and package these products.

 

Harmful consequences of deterioration of TOT in developing countries

1. Developing countries have to sell more exports in order to buy the same amount of imports. They have to increase the supply of exports which leads to a fall in commodity prices. This continues as a cycle in developing countries.
2. They have high levels of indebtedness → Falling exports prices and revenue makes it harder to service their debt. This leads to some countries borrowing money, but this leads to more indebtedness. This again leads as a cycle in developing countries as the supply of the commodities increases and the prices go down.
3. Some developing countries overused their resources in order to increase their supply of commodities and export revenue, but this lead to negative externalities.

Paper 3 Question

 

Find the Terms of Trade index of Country X from Year 1 to Year 6.