Terms of Trade

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

Consequences of long-term changes in the ToT for the domestic economy These changes are more important for developing countries, specially if their production is mainly focused on a few commodities for export. This makes these countries more vulnerable: if prices of these commodities experience long-term trends in one direction or wide and abrupt fluctuations over short periods of time, effects are felt more strongly.

Impacts within the domestic economy: Long term improvements in ToT redistribute global output and income towards the country experiencing the improvement. This allows increased investment and increased imports of capital goods, which can have a positive impact on economic growth. Impacts within the domestic economy: If increase in X prices: it is likely to be lasting if caused by a long-term increase in D for X. This will favour technological change, increased employment and greater investment. If decrease in M prices: will impact consumers and firms (lower prices in consumer or capital goods)

Long-term deterioration in ToT redistributes global output and income away from the country experiencing the deterioration. Increasing quantitites of exports are needed in order to maintain a certain amount of imports. Reduces possibilities for investment and diminishes the quantity of imports needed for production Empirical research shows that developing countries which are non-oil commodities exporters have experienced deteriorating ToT over long periods of time.

Figure 1 - A. Real agricultural commodity price trends (1980 = 100) (deflated by the price index of manufactured exports of industrial economies) On average, prices of key agricultural commodites fell by 50% between 1980 and 2000.

In the case of certain products, including sugar and cotton the fall has been even greater.

Long term deterioration in ToT in developing countries Causes Low YED for primary products (as compared to high YED for manufactured products). As Y↑, in relative terms, a lower fraction of the increase is spent on primary products and a higher fraction on manufactured products. D for prim products has slower growth and prices of these products tend to fall relative to prices of manufactured products.

Food has a low PED Some non-food primary products (rubber, cotton) face competition from synthetic alternatives, leading to low YED for these products, which puts downward pressure on the prices. Technological advances in agriculture. Slow demand growth and increased supply have caused prices to decrease even further. Protection of agriculture in DCs. In order to protect farmers’ income, governments in DCs: impose tariff and other trade barriers on imports of agricultural commodities, which restricts world D for protected agricultural products grant export subsidies, which increase world supply Effect is ↓p.

High YED for imports in developing countries: Wealthy consumer groups spend on manufactured luxury goods Western products becoming popular in LDCs (eg Coca-Cola and brand-name clothes) →Large D growth for high-priced imports Impacts of increased productivity In DCs: increased wages (low UE, powerful labour unions). Instead of an increase in supply of manufactured goods (rightward shift of S), productivity increases cause a decrease in S. Depending on which effect is larger, P could ↑. In LDCs: always decrease in prices (high UE, weak labour unions). Therefore: P of manuf goods tend to ↑ and P of primary pdts tend to ↓.

Oligopolistic mkt structures in more DCs Manufactured goods in DCs often produced by oligopolistic firms with more mkt power Primary pdts in LDCs produced in more competitive mkts, with low degree of mkt power.

Impacts of deteriorating ToT in LDCs Countries which export mainly commodities: falling X rev and decline (or weak increase) of Y and output. This has negative effects on agricultural UE, investment, farm incomes and rural poverty. It also seriously worsens BoP, as well as Growth and development performance