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4.1.4 Terms of trade

Terms of trade 

An index number which shows value of country's exports relative to imports. 

 In absolute/comparative advantage theory refers to the barter exchange rate that two trading partners exchanged their goods at. Improvement in ToT for one country means their exports are valued at more than the other's. 

 A nation's living standards improve if its ToT improve because it is able to consume more imports for the work it puts into producing its exports. 

Terms of trade = index of export prices/index of import prices x 100  

The lower the terms of trade, the higher the price competitiveness of the country. 

Price competitiveness can be measured in these terms. 

Factors influencing a country's terms of trade 

Factors affecting the price of a country's exports (same as factors influencing price competitiveness) 

e.g productivity, unit labour costs, NMW, etc. 

 Factors affecting price of country's imports 
Prebisch-Singer hypothesis 

As the YED of primary products is more inelastic than that of manufactured goods, as world incomes rise, developing countries will be able to buy fewer imports with the revenue from their exports, leaving them worse off. 

 Developing countries terms of trade decline. 

 Assuming that developing countries produce primary products (e.g Brazil produces coffee, Zambia produces copper) 

 e.g though world demand for coffee rises and world price for coffee rises, Brazil is able to afford fewer and fewer manufactured goods over time. 

 Eval: 

 Not all primary products are YED inelastic (e.g oil, asparagus, blueberries) If countries specialise in these primary products they will not experience declining terms of trade. 

 In practice this PP prices haven't fallen by much relative to manufactured good prices. Zambia saw growth rates of over 5% over the last decade due to price of copper on world markets. 

 Supply curves of manufactured goods often shift out due to innovation, so prices fall. 

 PES is often more inelastic for primary products so as demand shifts out, prices rise more. 

 YED may not actually be inelastic for a primary products - much of world income increases are in developing countries, where initially demand for primary goods would rise more than demand for manufactured goods. 

Impact of changes in a country's terms of trade  

Declining terms of trade can mean declining living standards as economy must put out more in exports to get a given no. of imports. 

 But if you export more, your trade balance and BoP moves towards a surplus, and this can be good for output and employment. 

 you have to consider the elasticities of imports and exports in eval. 
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