Chapter 76 & 77: HL extension – Terms of trade (3.5)
HL extensions
 Definition, measurement and calculation of terms of trade
 Improvement and deterioration of terms of trade
 Short term influences on the terms of trade
 Long run influences on the terms of trade
Measurement
Causes of
changes in the
terms of trade
•
Explain the meaning of the terms of trade
•
Explain how the terms of trade are measured
•
Distinguish between an improvement and a deterioration in the terms of trade
•
Calculate the terms of trade using the equation: Index of average export
prices/index of average import prices x 100
•
Explain that the terms of trade may change in the short term due to changes in
demand conditions for exports and imports, changes in global supply of key
inputs (such as oil), changes in relative inflation rates and changes in relative
exchange rates
•
Explain that the terms of trade may change in the long term due to changes in
world income levels, changes in productivity within the country and
technological developments
Intro questions:
1. How would a depreciation of the Canadian dollar affect USA and Mexico’s terms of trade?
2. How might a deterioration of a country’s terms of trade lead to inflation?
3. Why might an improvement of the terms of trade have negative effects for an economy?
4. How have deteriorating terms of trade affected the majority of less developed countries during the past 40
years.

Definition, measurement and calculation of terms of trade
Definition: “Terms of trade index “
The terms of trade index is the (indexed) average price of exports over the (indexed) average
price of imports at a given point in time (tn). A decrease in the terms of trade index shows a
deterioration of the terms of trade.
Index of ToT at tn =
Index of the average price of exports at tn
x 100
Index of the average price of imports at tn
Calculate the missing values in the table. Explanation forthcoming under next heading.
2007
Av price of X
Av price of M
Index of ToT

100
2008
112
115
x
2009
119
x
101.7
2010
123
125
x
Improvement and deterioration of terms of trade
The index in figure 76.1 shows how the terms of trade for China have deteriorated by 20% over a 10 year period.
(Source: World Bank at www.worldbank.org)
However…do not confuse ‘improved’ with better or ‘deteriorated’ with worse! An improvement in the terms of
trade means that the Home economy gets more imports for exports – but it also means that trade partners get less for their exports.
In the same way, a deterioration in the terms of trade mean that Home country exports are actually cheaper – this might lead to an
improvement in current account in the balance of payments.

Short term influences on the terms of trade
The terms of trade change over time. In the short run, a number of influences will cause a change in the terms of trade:

Perhaps the most obvious influence on the terms of trade is a change in the exchange rate – indeed this is the most likely
reason for the decline in China’s terms of trade over the past decade as China has strived to keep the Yuan rate low.
Depreciation of the home currency worsens the terms of trade while depreciation of trade partners’ currencies improves
home’s terms of trade.

Increased demand for a country’s exports will improve the terms of trade –due to both the exchange rate effect and the
price effect on export goods. Increased supply of exported goods will lower the terms of trade – especially goods which
are demand inelastic in price.

It is possible to intentionally alter the terms of trade by the use of trade barriers, intervention purchasing/selling of the
home currency and devaluation.

A booming economy can attract investment funds and cause the currency to appreciate and thus the terms of trade to
increase. It is also possible that demand pull inflation causes depreciation and a deterioration of the terms of trade.

Long run influences on the terms of trade
In the long run, there are a number of fundamental factors which will have an impact on the terms of trade:

Increased investment and supply-side policies which increase long run aggregate supply can lower domestic prices
relative to trade partners. Increased productivity would have the same effect.

Increased world supply and market ‘gluts’ can depress the market for a country’s exports. This happened to a number of
coffee and oil producing nations during the 1980s and ‘90s.

Increasing incomes will shift demand towards secondary and tertiary goods with higher income elasticities, increasing the
terms of trade for industrialised countries and decreasing the terms of trade for countries dependent on exports of primary
goods.

Purchasing power parity theory (see Chapter 67) predicts that exchange rates will ultimately adjust to different inflation
rates in trading countries. Since the terms of trade are strongly linked to exchange rates, PPP adjustment of exchange rates
will naturally affect the terms of trade.
Chapter 77: HL extension – Consequences of a change in the
terms of trade (3.5)
HL extensions
 Terms of trade and redistribution effects
 Terms of trade, PED and the balance of payments
 Terms of trade, commodities and LDCs
Consequences of
changes in the terms
of trade

•
Explain how changes in the terms of trade in the long term may result in a
global redistribution of income
•
Examine the effects of changes in the terms of trade on a country’s
current account, using the concepts of price elasticity of demand for
exports and imports
•
Explain the impacts of short term fluctuations and long term deterioration
in the terms of trade of economically less developed countries that
specialize in primary commodities, using the concepts of price elasticity
of demand and supply for primary products and income elasticity of
demand
Redistribution effects
EFFECTS OF AN IMPROVEMENT IN THE TERMS OF TRADE
Good: Perhaps the most obvious effect is that a country which has improved its terms of trade will be able to consume more
imports and thus experience a general increase in living standards. Another effect of being able to get more for domestic goods is
that external debt servicing (i.e. paying off loans and interest) will be easier. Firms will also be able to import cheaper raw
materials and capital, which can enhance competitiveness.
Improved terms of trade can also improve the current account in the balance of payments. If exports are relatively inelastic, an
improvement in the terms of trade can increase export revenue and improve the current account, since the relative increase in price
will be greater than the relative fall in the quantity of export goods sold. The same holds true if imports are demand inelastic;
import spending would decrease.
Bad: As you may have guessed, if exports are demand elastic then an improvement in the terms of trade will cause export revenue
to fall – just as import spending would rise if the demand for imports is relatively elastic. Both would have a negative effect on the
balance of payments. A decrease in export revenue and/or an increase in import spending could lower national income and
adversely affect employment.
EFFECTS OF A DETERIORATION OF THE TERMS OF TRADE
Good: A decrease in the price of exports relative to the price of imports will lead to an improvement in current account if the price
elasticity of demand for exports is elastic. If the demand for exports is also price elastic then export revenue will increase and also
improve the current account balance. Increased demand for exports and/or decreased demand for imports will increase aggregate
demand and perhaps increase job opportunities.
Bad: Higher prices of foreign goods will not only lower consumption possibilities for households, but increase foreign debt
burdens and make imported factors dearer. A deterioration of the terms of trade will have a negative effect on the current account if
the demand for export goods is price inelastic, as total export revenues will fall. Inelastic demand for imports will also be negative
for the current account, as total import spending will rise.
Ugly: See terms of trade for developing countries further on.

Terms of trade, PED and the balance of payments
As shown in Chapter 9 (Applied economics; commodity price fluctuations), primary good prices will fluctuate a great deal more
than prices for secondary goods.
P ($)
S1
S0
S2
Price fluctuations of
primary goods
Price fluctuations of
secondary goods
DImports of secondary goods
DImports of primary goods
Q/t
PED, TERMS OF TRADE AND BALANCE OF PAYMENTS
As the relative price of primary goods fallen more than that of secondary goods, primary good exporters have had a worsening
in their terms of trade.
I: Primary goods exporters
II: Secondary goods exporters
P (index in
constant USD)
P (index in
constant USD)
S0 (exports)
S1 (exports)
100
S0 (exports)
S1 (exports)
100
P1, secondary goods
60
80
P1, primary goods
Dprimary goods
Q0 Q1
∆↓export revenue > ∆↑ export
revenue; ∆↓current account
Q/t
The price of primary
goods falls relative
to secondary good;
the terms of trade
for primary goods
exporters has
worsened.
Dprimary goods
Q0
Q1
Q/t
∆↓export revenue < ∆↑ export
revenue; ∆↑current account
LOW YED AND FALLING PRIMARY GOODS PRICES
Here is how low yED for primary goods causes falling prices for commodities in the long run:
 Low income elasticity of demand for primary goods in more developed nations (MDCs) means that even though MDC
incomes increase, demand for primary goods increases proportionately less.
 Demand has also increased at a slower rate than supply since importers – primarily MDCs – have increasingly found ways
to substitute many primary goods. Also, increased efficiency in use of raw materials together with recycling has helped
lower the rate at which demand increases over time.
 Improvements in farming methods, new technology in extracting minerals, new methods of locating mineral sources…etc,
have all contributed to a remarkable increase in the supply of primary goods over the past 50 years.
P (index in
constant USD)
I: Primary goods exporters
S0
As the increase in supply of primary
goods (excluding oil) has been
outstripping demand for some 50
years, the long run price trend has
been decidedly downwards over the
long term.
S1
S2
SLR
100
70
LR trend, primary goods
D0
Q0

D1 DLR
QLR
Q/t
Terms of trade, commodities and LDCs
Developing countries are frequently highly dependent on a few commodities (primary goods) for export earnings. In fact, 62 out of
141 developing countries depended on non-oil commodities for over 50% of all export earnings in 2000 – and if oil is included, the
number rises to 95.1
(Source: UNDP, “Commodity Dependence and International Commodity Prices” 2010, pages 76 – 79)
UNDP, “Commodity Dependence and International Commodity Prices” 2010, pages 76 – 79
1
SUMMARY OF TERMS OF TRADE AND LDCS
In economic shorthand: supply for commodities has been outstripping demand for over 60 years → ∆↓price of commodities 
∆↓terms of trade (low PED for exports)  ∆↓export revenue  ∆↓current account and ↓∆Y.
The results of falling terms of trade for developing countries are almost always negative:

Higher costs of debt servicing as a greater quantity of exports are necessary to earn a given amount of foreign currency
with which to repay foreign debt.

Current account deficits often lead to increased borrowing – which in turn increases the debt burden.

Falling commodity prices often encourage producers in developing countries to increase production of commodities –
which further depresses the world price of the commodity.

Deteriorating terms of trade reduce much-needed imports such as capital, intermediate products in production, and fuel.
All are needed to industrialise and increase value-added output.
However…Australia, one of the largest exporters of commodities in the world, has seen GDP growth of an average
5.3% annually in the latter half of the 2000s – more than half of this growth came from commodity exports. Most of this is due to
China’s incredible appetite for raw materials. For example, between 2000 and 2010, Chinese imports (in USD terms) of iron
increased by a factor of 42.5 and coal by a factor of 248! 2 Exports of minerals and agricultural goods made up 57% of Australia’s
exports in 2012 and exports made up 20% of Australian GDP – which means that 11.45 of export revenue came from primary
goods.
 The terms of trade: The terms of trade for Australia improved monumentally from 2000 onward – by over 70% just before
the economic crises hit in 2008. This was caused by high demand for Australian commodity exports and…
 …the exchange rate, which was export-led primarily. As the mining sector expanded to feed China’s voracious appetite
for raw materials, FDI poured in as foreign mining syndicates established in Australia. By 2010, 32% of all FDI inflows
to Australia were in the mining sector.3 This helps explain the current account deficit – billions were coming in on the
financial account!
 Current account: So, high growth, massive FDI and a strong exchange rate. This indicates a hefty current account deficit
according to economic theory. I checked; Australia has something of a current account record in the OECD; the country
has been running a current account deficit since 1972. So, while this makes the deficits during the 2000s somewhat less
intimidating, one can still see that rising terms of trade and a strengthened Australian dollar almost consistently worsened
the current account during the 2002 to 2008.
PREPARING FOR EXAMS
SHORT ANSWER QUESTIONS (10 MARKS EACH)
1.
“A current account deficit damages the domestic economy.” Discuss.
2.
Explain how a country which is experiencing a “boom” in the domestic economy might see the current account go into a
deficit.
3.
How might a country’s exchange rate influence the balance of payments?
4.
How might deteriorating terms of trade improve the current account in the balance of payments?
2
http://www.reuters.com/article/2011/11/30/us-australia-china-idUSTRE7AT2HY20111130 and
http://www.theaustralian.com.au/business/mining-energy/china-forecast-suggests-commodities-boom-has-peaked/story-e6frg9df1226291178832
3
http://www.business.nsw.gov.au/invest-in-nsw/about-nsw/trade-and-investment/foreign-direct-investment-in-australia-byindustry
5.
“An appreciation of the exchange rate is always beneficial to an economy”. Discuss.
6.
Why might a devaluation of a country’s currency not necessarily improve the current account in the short run?
EXTENDED RESPONSE QUESTIONS (25 MARKS EACH)
1.
(a)
(b)
What problems might arise for a country running a current account deficit? (10 marks)
How might the deficit be reduced? (15 marks)
2.
(a)
(b)
Distinguish between the “terms of trade” and the “balance of trade”. (10 marks)
How might both be affected by a fall in the country’s exchange rate? (15 marks)
(a)
Explain how a country might have a consistent current account deficit for longer periods. (10 marks)
(b)
Is this necessarily a serious problem? (15 marks)
Taken out of Ch 69.
4.
a)
Account for the difficulties of establishing a common currency amongst 10 countries. (10 marks)
b)
Discuss the costs and benefits of establishing a common currency. (15 marks)
3.
Summary and revision
1. Improved terms of trade have positive re-distribution effects:
a. Living standards improve as consumers can consumer more imports and
have more choice
b. External debt decreases in terms of export revenue
c. Firms can import cheaper factors of production in terms of exports
d. Better terms of trade can improve current account if exports and/or imports
are price inelastic
2. Improved terms of trade can also come with disadvantages:
a. Current account might worsen since exports are dearer and imports are
cheaper
3. A deterioration of the terms of trade has possible benefits:
a. As relative export prices have fallen, there might be an improvement in
current account
b. Increased exports might increase aggregate demand and thus income
4. Possible disadvantages of deterioration of the terms of trade:
a. Higher import prices impact on consumers in terms of choice and living
standards
b. Export-driven economies might see the external debt burden increase
c. For export goods that are price inelastic, a deterioration of the terms of
trade might lead to a worsening of current account
5. Low PED, PES and yED for primary goods has disadvantaged primary goods
exporting LDCs:
a. Low PED and PED has led to extreme price volatility over many years
b. Low yED for primary goods has often meant that demand from MDCs for
primary goods has not increased in tune with growth
c. Supply outstripping demand has lowered commodity prices in real terms
over almost 50 years
6. Falling commodity prices has led to a deterioration of the terms of trade for
developing nations over most of the past 50 years. Effects of this include:
a. Current account deficits as export revenues fall
b. Increased debt burdens since much of the debt is accrued from the foreign
sector and export revenues are needed to service the debt
c. Imports of much-needed capital goods become dearer in terms of export
revenues