Terms of Trade (Edexcel A Level Economics A)

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

Calculation of the terms of trade

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• 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)

Factors influencing a country's terms of trade

1. Relative inflation rates: Inflation increases the price of goods/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 elastic then it is likely to worsen the terms of trade

2. 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

3. 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 contribution that net exports make to GDP, changes to the terms of trade can have far reaching impacts on an economy. These include

  • Changes to the current account balance in the Balance of Payments

  • Changes to national output (GDP)

  • Changes to unemployment levels

  • Changes to the level of international competitiveness

  • Changes to disposable income

  • Changes to standards of living

• The impact of changes to the terms of trade are more complex than assuming that an improvement in the terms of trade is good and a deterioration is bad

  • E.g. Improvement in terms of trade → one unit exports buys more imports → standard of living improves

    • However, it depends on what caused the improvement and on the price elasticity of demand for exports and imports

    • If the improvement was caused by an increase in the price of exports, then following the law of demand fewer exports will be consumed by foreigners. How much fewer depends on the PED for exports. This could worsen the standard of living

PED and Changes To the Terms of Trade