Understanding the Terms of Trade (ToT) • The ToT is the ratio of the average price of exports to the average price of imports:
It is a measure of the amount of imports that can be exchanged per unit of exports. • Assume that Finland and Russia trade only mobile phones (Finland) and caviar (Russia): One mob phone = USD 300 One hectogram caviar = USD 100 ToT Finland = 300/100 = 3 → One phone buys 3 hectograms caviar ToT Russia = 100/300 = 0.33 → One hect caviar will buy 0.33 mob phones.
Suppose price of caviar ↑ to USD 200: ToT Fin = 300/200 = 1.5 (↓) Deterioration of ToT ToT Rus = 200/300 = 0.66 (↑) Improvement of ToT The distribution of global output has changed in favour of Russia, which can now get more imports for a given amount of exports (or the same quantity of imports for a smaller amount of exports). We then say that Russia’s ToT have improved. The opposite holds for Finland, which can now get fewer imports for the same amount of exports. Finland’s ToT have deteriorated.
Since ToT = Average PX / Average PM, then: • ↑Price M or ↓Price X → Deterioration ToT • ↓Price M or ↑Price X → Improvement ToT • We cannot always conclude Improvement (Deterioration) of ToT makes a country to be better (worse) off. This depends on the causes of changes in the ToT. • READ SECTION Causes of changes in the ToT (HL topic), page 392.
ToT and the Balance of Trade • Balance of Trade = Value of X – Value of M • With only two goods being exported and imported: • Value of X = X revenues = p1q1+p2q2 • Value of M = M expenditures = p3q3 + p4q4 • Therefore, a change in ToT resulting from a change in PM(PX) will affect the value of imports (value of exports).
Consequences of changes in de ToT for the Balance of Trade / Current account • A country will gain from a change in its ToT if it can ↑ its X revenues or if it can ↓ its M expenditures. In both cases CA improves. • IMPORTANT: whether an improvement in the ToT leads to an improvement of the CA depends on the PED for exports and imports.
From Micro theory we know: • Elastic Demand (PED>1): ↑P → ↓TR, ↓P → ↑TR • Inelastic Demand (PED<1): ↑P → ↑TR, ↓P → ↓TR • Imports: • Elastic Demand (PED>1): ↑P → ↓M exp, ↓P → ↑M exp • Inelastic Demand (PED<1): ↑P → ↑M exp, ↓P → ↓M exp • Exports: • Elastic Demand (PED>1): ↑P → ↓X rev, ↓P → ↑X rev • Inelastic Demand (PED<1): ↑P → ↑X rev, ↓P → ↓X rev
Improvement of ToT (caused by ↑PX or↓PM): • If PED for X or M is larger than 1→ deterioration CA • If PED for X or M is smaller than 1→ improvement CA • Deterioration of ToT (caused by ↑PM or↓PX): • If PED for X or M is larger than 1→ improvement CA • If PED for X or M is smaller than 1→ deterioration CA
Causes of changes in ToT • Changes in exchange rates • Changes in demand for an export product: price and quantity move in the same direction→ effects on CA independent of PEDs • Changes in supply of an export product: price and quantity move in opposite directions→ effects on CA depend on PEDs
Changes in exchange rates • Depreciation/Devaluation of dom. currency → ↑ToT. • If PED > 1: Improvement of CA • If PED < 1: Worsening of CA • Appreciation/Revaluation of dom. currency → ↓ ToT. • If PED > 1: Worsening of CA • If PED < 1: Improvement of CA
Changes in Demand for an X product • Increase in foreign D for an X product: D shifts right → both Q exported and Price ↑ and X Revenues increase regardless of PEDs. Hence, CA improves • Decrease in foreign D for an X product: D shifts left → both Q exported and Price ↓ and X Revenues decrease regardless of PEDs. Hence, CA worsens
Increases in Supply of an X product • Technology improvements or increases in productivity shift S rightwards → ↑QX +↓PX: • If PED > 1 → ↑X Rev → Improvement of CA • If PED < 1 → ↓X Rev → Worsening of CA • Most manufactured goods are price elastic, so technology advances do not pose a problem and a lower price increases international competitiveness • Many primary (dus including agricultural) products are price inelastic. For exporters technology advances or productivity increases may lead to ↓X Rev and worsening of CA
Decreases in Supply of an X product • S can shift to the left for two reasons: • A restriction in the S of exports (eg: OPEC) • An increase in wages domestically leading to cost/push inflation → ↑P of exported good Therefore: • If PED < 1 → ↑X Rev → Improvement of CA • If PED > 1 → ↓X Rev → Worsening of CA • Benefits of cost push inflation will be only short-term, as Gov will counteract negative effects in the economy (inflation and recession) with monetary and fiscal policies.
However, oil exporters which restrict their S of oil benefit from long lasting effects on their CA, as oil has a low PED for exports (↑P→ ↑X Rev). In particular, OPEC countries have accumulated large surplusus in their CA. • On the contrary, oil importers have a low PED for imports of oil: ↑P→ ↑M Exp