1. Terms of Trade

2. Understanding the Terms of Trade (ToT)
The ToT is the ratio of the average price of exports to the average price of imports:

3. 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.

4. 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.

5. 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.

6. 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).

7. 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.

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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.

15. 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

16. 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.

17. 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)

18. 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.

19. 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.

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

21. 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.

22. 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.

23. 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 ↓.

24. 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.

25. 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