Terms of

trade
Measurement of Terms of trade:
the ratio of export prices to import prices

Index of export prices

Terms of Trade Index 100
Index of import prices

• Falling in TOT (unfavourable movement/deterioration of TOT/worsening

TOT):
means a country has to export a greater volume of its goods in order to
acquire the same volume of imports

• Increasing TOT (favourable movement/improvement of TOT):

means a country can export a smaller volume of its goods in order to
acquire the same volume of imports
 Terms of trade
a) Understanding and calculation of the terms of trade.
b) Factors influencing a country’s terms of trade, changes in:
• relative inflation rates
• relative productivity rates
• relative labour costs
• the exchange rate
• the prices of imports and exports.
c) The impact of changes in a country’s terms of trade on:
• export revenues
• living standards
• balance of trade
 Factors influencing the terms of trade
• Relative inflation rates
Relatively higher inflation rate than other countries->faster growth in export prices compared
with import prices->rising TOT
• Relative productivity rates
Higher productivity relative to other countries->higher domestic supply or lower domestic cost-
>higher price competitiveness of exports relative to products from other countries->lower TOT
• Relative labour costs
Unit labour cost=cost of employing labour per unit of output or production
Higher relative labour cost than other countries->higher prices of domestic products relative to
products from other countries->rising TOT
• Changes in exchange rates
Rising exchange rate->higher price of exports in terms of foreign currency and lower price of
imports in terms of domestic currency->rising TOT
 Factors influencing the terms of trade
• Changes in global demand or income
Increases in the global demand for a product cause its price to increase
Rising TOT in the exporting countries of this product and falling TOT in the importing countries
of this product
• Changes in global supply
Increases in supply lower global prices, causing a deterioration in the terms of trade of exporting
countries and an improvement for importing countries.
In agriculture, weather conditions such as drought or flooding, pests, animal diseases, etc.,
affect the supply of agricultural products.
• Changes in protectionism
Rising tariff on imports->price of imports increases->falling TOT
Rising export tariff->price of exports increases->rising TOT
Evaluative comments:
• Prioritisation of factors
• Different factors will be more important in different economies.
e.g. the price of oil will be highly important in Saudi Arabia, but not in other
countries
• Different factors will be more important at different times
• The importance of labour costs will depend on whether a country tends to
import and export labour-intensive or capital-intensive goods and services
 Effect of a change in export and import prices on balance of trade

Elasticity Price Value of imports Terms of trade Balance of Trade

change or exports
Exports Elastic Rise Improve Deteriorate
Fall Deteriorate Improve
Inelastic Rise Improve Improve
Fall Deteriorate Deteriorate
Imports Elastic Rise Deteriorate Improve
Fall Improve Deteriorate
Inelastic Rise Deteriorate Deteriorate
Fall Improve Improve
Effects of changes in terms of trade on the domestic economy
1. If an improvement in terms of trade is caused by a rise in export prices (with
elastic demand):

2. If an improvement in terms of trade is caused by a fall in import prices (with

elastic demand):

A fall in import prices will make goods made abroad more price competitive.
This will cause domestic consumers to switch their spending away from goods
produced in the domestic economy, towards imported goods, where substitutes
exist. This will be more significant for domestic firms where imported goods
are close substitutes for domestic goods. Domestic producers will therefore
lose market share. The balance of trade will deteriorate and aggregate demand
will fall.
 Case Study
The ‘terms of trade’ concept can be confusing. When economists say the terms of trade have improved,
they mean a country can buy more imports with a given quantity of exports. For this to happen, export
prices must have risen relative to import prices. However, the impact on the export revenues, the balance
of trade, economic growth and living standards will depend on why the terms of trade have improved and
how consumers and firms, both abroad and in the domestic economy, respond to these relative price
changes.

For example, in May 2017, Japan's current account surplus hit its highest level since 2007. For the year to
March 201 7, the surplus reached 20.2 trillion Japanese yen - equivalent to $1 77 billion. As a newspaper
reported, 'The scale of the surplus highlights the improvement in Japan's terms of trade. The cause of the
improvement in the terms of trade was a fall in oil prices. Because Japan is one of the largest importers of
oil in the world, oil prices will be weighted significantly in Japan's index of import prices. A fall in oil prices
will therefore improve Japan's terms of trade. It will also lower the value of oil imports, since demand for oil
is price inelastic; this is likely to have a significant impact on the balance of trade and was one of the
factors causing the current account surplus to widen.

However, if the terms of trade had 'improved' because Japan's export prices had risen, this might have
been caused by costs rising faster in Japan, compared to trading partners. In this case, Japan would be
losing price competitiveness in its export markets.
.
How this affects Japan's balance of trade will depend on how foreign consumers respond to these higher
prices. If demand for exports is price elastic, export revenues will fall. Japanese consumers are also likely
to switch to cheaper imports. So, in this case, an improvement in the terms of trade is likely to worsen the
balance of trade, reduce real GDP and increase unemployment.

Some emerging economies, such as Brazil, the United Arab Emirates, Russia and Chile, rely heavily on
commodity exports, for example soya beans, copper, rubber, oil. For these economies, changes in
commodity prices will have a big impact on their economic performance. From 2014, commodity prices fell
sharply. Analysis by Fitch Ratings showed that the drop in commodity prices led to a 20 percent decline in
the typical emerging market country’s terms of trade between 2014 and 2016. There was a worsening in
their terms of trade. According to some research, there was a close correlation between the rate of change
in emerging markets terms of trade and their level of economic growth between 2001 and 2016. A fall in
their terms of trade, caused by a fall in commodity prices, will cause export revenues to fall. This is
because the price elasticity of demand for commodities tends to be inelastic. As a result, the balance of
trade will deteriorate. This will set off a negative multiplier effect as aggregate demand falls.

In contrast. the rise in commodity prices from 2016 onwards would improve the terms of trade of
commodity exporters. This means a given quantity of exports can buy more imports. This is particular
beneficial for those emerging economies that import capital goods from developed countries to improve
infrastructure and productivity
 Practice Question:
If ltaly can produce 10 cars or 30 trucks. Would Italy be willing to import
cars from Germany if they can trade 1 car for 5 trucks?

Table 7 Opportunity cost

Recall Spain
of Wheat
1/2 Olive oil
of olive oil
2 Wheat
Portugal 2/3 Olive oil 3/2 Wheat

Whether trade takes place will depend on the terms of trade between the two countries.
• As shown in Table 7, Portugal could produce 1.5 units of wheat for every 1 unit of olive oil. Portugal
will only choose to specialise in the production of olive oil and then trade to obtain wheat, if it can
receive at least 1.5 units of wheat for 1 unit of olive oil.
• Similarly, Spain will only choose to specialise in the production of wheat and then trade to obtain olive
oil, if it can give Portugal less than 2 units of wheat for every 1 unit of olive oil received. Otherwise, it
will not gain from trade.

Trade will only be mutually beneficial if the terms of trade are between 1.5 units of wheat for
1unit of olive oil and 2 units of wheat for every 1 unit of olive oil.