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Terms of trade

The terms of trade measure the relative prices of the products that we export compared to the prices of goods and services we import

Comparative advantage: countries should specialise in production of the goods/services in which they have a comparative advantage

How to calculate comparative advantage: which good/service is the country relatively better at producing?

If countries specialise in the good/service in which they have a comparative advantage, they can move outside their PPF and gain from trade. The distribution of these gains depends on the terms of trade.

How to measure terms of trade:

Terms of trade index=((Average export price index)/(average import price index))*100

(start from base year 100)

If the terms of trade index goes up, the terms of trade have improved.

If the terms of trade index goes down, the terms of trade have deteriorated.

If PED=0

If the terms of trade improve, more imports can be bought with the same amount of export revenue

If the terms of trade deteriorate, less imports can be bought with the same amount of export revenue

Factors that affect the terms of trade:

A rise in the currency (improvement)

A fall in the currency (deterioration)

Rise in domestic inflation < rise in global inflation (improvement)

Rise in domestic inflation > rise in global inflation (deterioration)

A rise in the Demand for exports (improvement)

A fall in the Demand for exports (deterioration)

A rise in the Demand for imports (deterioration)

A fall in the Demand for imports (improvement)

How much will the change in terms of trade affect living standards and balance of payments?

PED

When export/import prices change, it is important to know the export and import revenues to see the effects on X-M, aggregate demand and living standards.

E.g. inelastic demand for exports -> export revenue relatively unchanged, elastic demand for imports -> import revenue will be different -> X-M will be different if there is a change in import prices, relatively unchanged if there is a change in export prices

Balance of payments: X-M

assess how PED affects export and import revenues, then use X-M

e.g. rise in exchange rate, imports elastic -> imports cheaper, increase in demand for imports (as demand is elastic), therefore M increases, X stays the same, therefore X-M decreases, so balance of payments decreases.