Terms of trade notes

Basics

Prices of exports and imports are measured in terms of domestic currency

Measures P of X relative to P of M
Measures the amount of Ms that can be bought per unit of Xs
Inc. P of X (when P of M is constant)
o = more Ms can be bought with the same quantity of Xs

TOT improvement / deterioration

Improvement:
o An inc. in the value of the ratio of average export prices to average
import prices.
o (when price of exports inc. / price of imports dec. the value of terms
of trade inc.)
o Fall in the opp. cost of imports
Deterioration:
o A dec. in the value of the ratio of average export prices to average
import prices
o (when price of imports inc. / price of exports dec. the value of terms
of trade dec.)
o Rise in the opp. cost of imports
Factors that caused changes in TOT
Short term
Inflation

Higher rate of domestic inflation = countrys export prices

increase relative to its import prices
At the same time, this corresponds to a deterioration in the terms of
trade of countries that import goods from the high inflation country.
Changes in relative inflation rates - if a country experiences inflation,
then the price of its exports will rise so their will be an improvement in
its terms of trade.

Exchange
rate

Changes in exchange rates - if a country experiences appreciation,

then the price of its exports will rise so their will be an improvement in
its terms of trade.
Appreciation - price increases
put back into equation improvement in terms of trade

Global
demand

Changes in demand conditions for exports and imports - if world

demand for a country's exports increases then its terms of trade will
improve.

Global

Changes in global supply of major resources, such as oil - if an oil

Terms of trade notes

supply

exporting country increases its supply, then the price of oil will fall and
the country's terms of trade will worsen.

Long term
Growth in
income global demand

Changes in world income levels - as incomes rise more is spent

on secondary and tertiary goods, rather than primary goods
hence this increases the terms of trade for more industrialised
countries but worsens the terms of trade for developing countries
exporting primary goods.

Productivity

Increased productivity - government spending aimed at increases

long run aggregate supply, may lower costs (lower ATC) to firms
and therefore reduce domestic consumer prices. Therefore
improving the terms of trade.
TOT deteriorate:
Lower Cost Lower export price, Increase export quantity

Technological
advances

Improved technology - this can increase efficiency and therefore

lower firms' costs, so consumer prices fall. This means that the
country's terms of trade improve.
TOT deteriorate:
average Export prices will decrease relative to import prices
increase in export quantity.

Trade
protection

A small country that uses trade protection to restrict imports or

expand exports cannot affect world import and export prices, and
faces a perfectly elastic world supply curve.
if a country has a large share in the world market for an import or
export good, it may be able to affect the level of
world prices.
For example, it is likely that the United States, having a large
share of the worlds automobile imports, could lower world
demand for automobiles, and therefore lower the prices of
automobile exports of other countries, by restricting its imports
through trade protection. This would result in an improvement in
the terms of trade for the United States. On the other hand,
subsidies granted by large producers of a good may result in an
increase in global supply and hence a fall in its price. There is
substantial evidence that subsidies
granted by the United States and the European Union on their
agricultural products have the effect of increasing global supply
and depressing world prices. Exporters of the same products

Terms of trade notes

(usually in developing countries) therefore face deterioration in
their terms of trade as the price of their export goods falls.