The Terms of Trade (Cambridge International A-Level Economics)

What are the terms of trade?

• Terms of trade refer to the ratio of a country’s average price of exports to the country’s average price of imports

• The relative price of imports and exports can have a direct bearing on the standard of living within a country

  • Exporting goods which are highly priced results in higher incomes and the ability to buy cheaper imports
  • The terms of trade capture the relationship between the average prices of a country's exports and imports

Calculating the terms of trade

$\mathrm{Terms} \mathrm{of} \mathrm{trade}=\frac{\mathrm{Index} \mathrm{of} \mathrm{average} \mathrm{export} \mathrm{prices}}{\mathrm{Index} \mathrm{of} \mathrm{average} \mathrm{import} \mathrm{prices}}\times100$

• The index for exports and imports is created in much the same way that a consumer price index is created (using a weighted basket of imports and exports)

Worked Example Calculate the terms of trade for Country X. State if the terms of trade have improved or worsened. In the final column explain what that means for country X

Year	Index of average export prices	Index of average import prices	Calculation of terms of trade	Terms of trade	Improvement or deterioration?	Explanation
2012	100	100
2013	100	107
2014	112	108
2015	115	110

Worked solution

Year	Index of average export prices	Index of average import prices	Calculation	Terms of trade	Improvement or deterioration?	Explanation
2012	100	100	(100÷100)×100	100	Baseline	Export and import prices are equal
2013	100	107	(100÷107)×100	93.5	Deterioration	Export prices have fallen relative to import prices - Country X must export more to buy the same quantity of imports
2014	112	108	(112÷108)×100	103.7	Improvement	Export prices have risen relative to import prices - Country X can buy more imports for the same quantity of exports
2015	115	110	(115÷110)×100	104.5	Improvement	The terms of trade continue to improve - Country X's exports are becoming relatively more expensive, raising purchasing power over imports

Causes of changes to a country's terms of trade

Relative inflation rates

• Inflation increases the price of goods and services within a country
• This means that their price is now more expensive to the rest of the world
• If the exports are price inelastic in demand, this will improve the terms of trade
• If price elastic then it is likely to worsen the terms of trade

Relative productivity rates

• Continuous improvements in productivity can lower costs and these can be passed on in the form of lower prices
• Lower prices for export products will mean that the terms of trade will deteriorate i.e. fewer imports can be bought with one unit of exports

Changes in exchange rates

• Exchange rates constantly change the price of exports and imports
• If prices change then the terms of trade between the two countries change
• Specific data would need to be provided in order to determine if the terms of trade have improved or deteriorated for each trading partner

Impact of changes in the terms of trade

• Depending on the combination of net exports made up in the balance of payments, changes in the terms of trade can have significant macroeconomic effects
• Key impacts include effects on: export revenue, import expenditure, the current account of the balance of payments, real incomes and the standard of living

• An improvement in the terms of trade generally raises the standard of living if export revenue holds - the country can buy more imports for the same export effort
• A deterioration generally reduces purchasing power over imports - the country must export more to maintain the same import volume
• The overall effect on the current account of the balance of payments depends critically on the PED of both exports and imports

Exam Hint Always show your working when calculating the terms of trade - state the formula, substitute the values and round to one decimal place.

A common error is to divide import prices by export prices rather than export prices by import prices, which inverts the result entirely. Remember: exports on top.

When analysing the impact of a terms of trade change, always link to PED before stating the outcome. The direction of the terms of trade change alone does not determine whether export revenue rises or falls - the elasticity of demand is the deciding factor.

An improvement can worsen the current account if export demand is elastic; a deterioration can improve it if demand is elastic.