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3.5. Terms of Trade

A country’s terms of trade measures a country’s export prices in relation to its import prices, and is expressed as:

For example, if, over a given period, the index of export prices rises by 10% and the index of import prices rises by 5%, the terms of trade are:110 x 100 / 105= 104.8This means that the terms of trade have improved by 4.8%.When the terms of trade rise above 100 they are said to be improving and when they fall below 100 they are said to be worsening.

Real life example – 2011 is the base year

In 2012, the island of Madagascar had an index of export prices of 15% (115) over the previous year and an index of import prices of 7% (107) over the previous year.

Madagascar's TOT = 115 / 107 X 100 = 107.5

The results show an improvement of 7.5% in the TOT.

Calculate the missing values in the table.

2007 2008 2009 2010Av price of X  x 112 119 123Av price of M  x 115 x 125Index of ToT 100 x 101.7 x

Country data

http://data.worldbank.org/indicator/TT.PRI.MRCH.XD.WD

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Improving vs worsening Terms of Trade

Improvement in the Terms of Trade

An improvement in the terms of trade must mean that one of the following changes has taken place:

• Export prices have risen, import prices have stayed the same• Export prices have risen, import prices have fallen• Export prices have risen faster than import prices• Export prices have fallen by less than import prices• Export prices have stayed the same but import prices have

fallenAn increase in the terms of trade ratio is generally described as an improvement, or favourable movement, in the terms of trade. This is because the same volume of exports will now buy more imports.

Worsening/deterioration in the Terms of TradeA decrease in the terms of trade ratio is generally described as deterioration or a worsening or unfavourable movement, in the terms of trade. This is because the country can afford fewer imports with the same volume of exports.

Deterioration in the terms of trade must mean that one of the following changes has taken place:

• Export prices have fallen, import prices have stayed the same• Export prices have fallen, import prices have risen• Export prices have fallen faster than import prices• Export prices have fallen by more than import prices• Export prices have stayed the same but import prices have

risen

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China’s Terms of TradeThe index in shows how the terms of trade for China have deteriorated by 20% over a 10-year period.

(Source: World Bank at www.worldbank.org)

However…do not confuse ‘improved’ with better or ‘deteriorated’ with worse! An improvement in the terms of trade means that the Home economy gets more imports for exports – but it also means that trade partners get less for their exports. In the same way, a deterioration in the terms of trade mean that Home country exports are actually cheaper – this might lead to an improvement in current account in the balance of payments.

Causes of changes in the Terms of TradeShort-runThe terms of trade is the price relationship between a country's exports and imports and will, therefore, be influenced by all the factors, which determine the prices of imports and exports.

In the short-run, changes in relative prices of imports and exports will be caused by fluctuations in exchange rates, particularly where countries operate a floating exchange rate system. Exchange rate volatility may be caused by changes in trade, capital flows, interest

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rates, speculation, inflation and use of foreign currency reserves by the government.

You will recall that a depreciation of the exchange rate causes import prices to increase and export prices to decrease, while an appreciation causes the opposite effects.

Also in the short-run, there may be considerable fluctuation in the prices of commodities, which will affect the terms of trade. This is particularly true for agricultural commodities, the supply of which is often affected by drought, floods, diseases, etc. Given that the demand for and supply of these commodities is highly inelastic the change in supply will cause a proportionately greater change in price.

Figure 1 Impact on price of primary commodities

In Figure 1, the relative inelasticities of demand and supply have caused a large fall in price in response to the increase in supply from S to S1. Try drawing the same diagram with more elastic demand and supply curves and note the less pronounced effect on price.

Long-runIn the longer term, changes in the terms of trade are likely to be determined by those factors, which exert a long-term influence on the demand for, and supply of, a country's exports and imports.For the developing countries, who export mainly primary goods and import manufactured goods, their export prices have tended to fall over time due to a combination of increased supply of and reduced demand for their exports:

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• Supply has increased, mainly due to improvements in technology and, in the case of coffee, new producers entering the market.

• Demand has fallen / not risen rapidly, for a variety of reasons.

The reasons for demand falling include:• Development of synthetic substitutes e.g. plastics have

lessened the demand for several raw materials.• Low-income elasticity of demand for primary commodities

- as real world incomes have grown, the demand for primary commodities has increased less than proportionately.

• Agricultural protection - the developing countries, despite producing at lower cost, have found it difficult to break into the markets of the richer countries, as farmers there are often heavily subsidized and, in the case of the European Union, protected by a common external tariff.

• Miniaturization - modern microchip technologies have enabled products to become smaller, e.g. the personal computer, and this has necessitated less use of raw materials and caused demand to fall.

• Price inelastic demand for exports of primary commodities - compounding the problem of falling export prices, demand for primary commodities tends to be price inelastic, such that decreases in prices bring about less than proportionate increases in the quantity demanded.

The above is in sharp contrast to the situation faced by the more developed countries - the export prices of their manufactured goods has risen over time (high income elasticity of demand, multinational / monopoly control over supply and price) and they have benefited from cheaper import prices of primary commodities due to the factors described above.

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Elasticity of demand for imports and exports

This is because the terms of trade records relative price movements of exports and imports, while the current account of the balance of payments is concerned with export and import values (price x quantity bought / sold).

The impact of a change in the terms of trade on the trade balance will largely depend on the relative price elasticity of demand for exports and imports.

An improvement (favourable movement) in the terms of trade may worsen the trade balance - this will occur when the demand for exports and imports is price elastic.

An improvement in the terms of trade means that the price of exports increases relative to the price of imports.

Impact of an increase in terms of trade on balance of paymentsDeterioration (unfavourable movement) in the terms of trade may improve the trade balance. This will occur when the demand for exports and imports is price elastic.

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A worsening of the terms of trade means that the price of imports increases relative to the price of exports.

Impact of a decrease in terms of trade on balance of paymentsThe overall impact on the balance of payments current account of a change in the terms of trade depends on the combined price elasticities of demand for imports and exports. So:

• An improvement in the terms of trade will worsen the balance of payments current account if the demand for exports and imports is price elastic, and improve it if demand for exports and imports is price inelastic.

• Deterioration in the terms of trade will worsen the balance of payments current account if the demand for exports and imports is price inelastic and improve it if demand is price elastic.

Given that the developing countries' demand for exports and imports is relatively price inelastic, they have faced ever worsening balance of payments situations in response to their deteriorating terms of trade.

Source: http://textbook.stpauls.br/International/page_114.htm, accessed Saturday, October 17, 2015

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100

I: Primary goods exporters

Q/t

P (index in constant USD)

Q0 QLR

D0

SLR

LR trend, primary goods

As the increase in supply of primary goods (excluding oil) has been outstripping demand for some 50 years, the long run price trend has been decidedly downwards over the long term.

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DLR

D1

S0 S

1 S2

Situation for LEDCs

Low YED and falling primary goods pricesHere is how low YED for primary goods causes falling prices for commodities in the long run:

Low income elasticity of demand for primary goods in more developed nations (MDCs) means that even though MDC incomes increase, demand for primary goods increases proportionately less.

Demand has also increased at a slower rate than supply since importers – primarily MDCs – have increasingly found ways to substitute many primary goods. Also, increased efficiency in use of raw materials together with recycling has helped lower the rate at which demand increases over time.

Improvements in farming methods, new technology in extracting minerals, new methods of locating mineral sources…etc, have all contributed to a remarkable increase in the supply of primary goods over the past 50 years.

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Terms of trade, commodities and LDCs Developing countries are frequently highly dependent on a few commodities (primary goods) for export earnings. In fact, 62 out of 141 developing countries depended on non-oil commodities for over 50% of all export earnings in 2000 – and if oil is included, the number rises to 95.1

(Source: UNDP, “Commodity Dependence and International Commodity Prices” 2010, pages 76 – 79)

Summary of terms of trade and LEDCsIn economic shorthand: supply for commodities has been outstripping demand for over 60 years → ∆↓price of commodities ∆↓terms of trade (low PED for exports) ∆↓export revenue ∆↓current account and ↓∆Y. The results of falling terms of trade for developing countries are almost always negative:

Higher costs of debt servicing as a greater quantity of exports are necessary to earn a given amount of foreign currency with which to repay foreign debt.

Current account deficits often lead to increased borrowing – which in turn increases the debt burden.

Falling commodity prices often encourage producers in developing countries to increase production of commodities – which further depresses the world price of the commodity.

1UNDP, “Commodity Dependence and International Commodity Prices” 2010, pages 76 – 79

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Deteriorating terms of trade reduce much-needed imports such as capital, intermediate products in production, and fuel. All are needed to industrialise and increase value-added output.

However…Australia, one of the largest exporters of commodities in the world, has seen GDP growth of an average 5.3% annually in the latter half of the 2000s – more than half of this growth came from commodity exports. Most of this is due to China’s incredible appetite for raw materials. For example, between 2000 and 2010, Chinese imports (in USD terms) of iron increased by a factor of 42.5 and coal by a factor of 248! 2 Exports of minerals and agricultural goods made up 57% of Australia’s exports in 2012 and exports made up 20% of Australian GDP – which means that 11.45 of export revenue came from primary goods.

The terms of trade : The terms of trade for Australia improved monumentally from 2000 onward – by over 70% just before the economic crises hit in 2008. This was caused by high demand for Australian commodity exports and…

…the exchange rate , which was export-led primarily. As the mining sector expanded to feed China’s voracious appetite for raw materials, FDI poured in as foreign mining syndicates established in Australia. By 2010, 32% of all FDI inflows to Australia were in the mining sector.3 This helps explain the current account deficit – billions were coming in on the financial account!

Current account : So, high growth, massive FDI and a strong exchange rate. This indicates a hefty current account deficit according to economic theory. I checked; Australia has something of a current account record in the OECD; the country has been running a current account deficit since 1972. So, while this makes the deficits during the 2000s somewhat less intimidating, one can still see that rising terms of trade and a strengthened Australian dollar almost consistently worsened the current account during the 2002 to 2008.

Questions2 http://www.reuters.com/article/2011/11/30/us-australia-china-idUSTRE7AT2HY20111130 and http://www.theaustralian.com.au/business/mining-energy/china-forecast-suggests-commodities-boom-has-peaked/story-e6frg9df-1226291178832 3 http://www.business.nsw.gov.au/invest-in-nsw/about-nsw/trade-and-investment/foreign-direct-investment-in-australia-by-industry

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1: The Terms of Trade is an index similar in methodology to any

other index such as the Consumer Price Index (CPI). The index is set

to 100 in the base year and then changes are measured from this

base. The actual formula for the Terms of Trade is

Terms of Trade = __________________________________________________ x ______

Take the following example: in the first year, the weighted average of

export prices increased by 8% and the weighted average of import

prices rose by 4%.

Terms of Trade = ______________ x _____ =

This means that the TOT has _______________________

(improved/worsened). Whether or not this leads to an improvement

or worsening in the current account depends on elasticity of demand

for exports and imports.

In the second year, export prices fall by 2%, while import prices stay

the same.

Terms of Trade = ______________ x _____ =

Therefore the TOT has _____________________ (worsened/improved)

2: (i) Consider an improvement in the Terms of Trade as export

prices rise while import prices fall: If demand for exports and

imports is elastic, then

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(a)The rise in export prices leads to a _______________ (rise/fall) in

export revenues and a/an ____________________________

(improvement/worsening) of the trade balance.

(b) The fall in import prices leads to a ________________

(rise/fall) in import spending and a/an ________________________

(improvement/worsening) of the trade balance.

In conclusion, in this case, the improvement in the TOT has led to

a/an ________________________ (improvement/worsening) of the trade

balance as export revenues have _______________ (risen/fallen) while

import expenditure has _______________________. (Risen/fallen)

(ii) An improvement in TOT as export prices rise while import prices

fall: If demand for exports and imports is inelastic then:

(a) The rise in export prices leads to a _______________ (rise/fall) in

export revenues and a/an ____________________________

(improvement/worsening) of the trade balance.

(b) The fall in import prices leads to a ________________ (rise/fall) in

import spending and a/an ________________________

(improvement/worsening) of the trade balance.

In conclusion, in this case, the improvement in the TOT has led to

a/an ________________________ (improvement/worsening) of the trade

balance as export revenues have _______________ (risen/fallen) while

import expenditure has _______________________ (risen/fallen)

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(iii): A worsening in TOT as export prices fall while import prices

rise: If demand for exports and imports is elastic then:

(a) The fall in export prices leads to a _______________ (rise/fall) in

export revenues and a/an ____________________________

(improvement/worsening) of the trade balance.

(b) The rise in import prices leads to a ________________ (rise/fall) in

import spending and a/an ________________________

(improvement/worsening) of the trade balance.

In conclusion, in this case, the worsening in the TOT has led to a/an

________________________ (improvement/worsening) of the trade balance

as export revenues have _______________ (risen/fallen) while import

expenditure has _______________________ (risen/fallen)

(iv): A worsening in TOT as export prices fall while import prices

rise: If demand for exports and imports is inelastic then:

(a) The fall in export prices leads to a _______________ (rise/fall) in

export revenues and a/an ____________________________

(improvement/worsening) of the trade balance.

(b) The rise in import prices leads to a ________________ (rise/fall) in

import spending and a/an ________________________

(improvement/worsening) of the trade balance.

In conclusion, in this case, the worsening in the TOT has led to a/an

________________________ (improvement/worsening) of the trade balance

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as export revenues have _______________ (risen/fallen) while import

expenditure has _______________________(risen/fallen).

Why/how do the Terms of Trade change?

In the short run, the TOT is affected by movements in the exchange

rate caused by swings in capital movements. These can be very large

as speculators and dealers react quickly and with large amounts of

money to changes in interest rates and anticipated changes in

exchange rates, share prices, interest rates etc. In the long run, it is

the movement in domestic prices affected by the rate of

inflation/deflation and productivity, which determine the trend of a

country’s exchange rate and consequently its TOT.

If domestic inflation is higher than a major trading partner, then

export prices _____________ (fall/rise) relative to import prices. This

will lead to a _______________________ (deterioration/improvement) in

the TOT. If foreign inflation is higher, then the TOT will ______________

(improve/worsen) because a country’s exports will become

relatively __________ (more/less) expensive.

Productivity is defined as the amount of output produced per worker

per hour, per year. As productivity improves prices ______________

(rise/fall). Therefore, countries with high productivity will produce

goods at ___________________ (higher/lower) costs than others and so its

export prices _____________ (fall/rise/rise at a slower rate). So the high

level of productivity leads to a _____________________________

(improvement/worsening) of the Terms of Trade.

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