The Terms of Trade attempt to explain that the price - not volume - of imports and exports are what is important. It thus measures the average price gained from exports, and the average price gained from imports in the following formula:
By working out the Terms of Trade we can work out two distinct things:
1) Whether global output has increased or decreased
2) Where that output is being generated
Let's have a look at some exaples:
| China | Chocolate Imports | Phone Exports |
| 2001 | $1 | $20 |
| 2002 | $1 | $40 |
Firstly, we have no idea how many chocolate bars or how many phones are being bought or sold. BUT, that doesn't stop us working out our Terms of Trade. Using the equation, we can see that:
2001 ToT for China
= 20/1= 20
2002 ToT for China = 40/1= 40
What we are therefore saying is that, when import prices remain constant and export prices rise, we now have (in this case) a terms of trade improvement, which allows us to either buy more imports or spend that excess money elsewhere.
What if this were not the case though? What if export prices rose at a faster rate than import prices? Look at the table below:
| China | TV imports | Phone Exports |
| 2002 | $1 | $40 |
| 2003 | $2 | $40 |
Using the equation, we can see that:
2002 ToT for China
= 40/1= 40
2003 ToT for China = 40/2= 20
What we are therefore saying is that, when export prices remain constant and import prices rise, we now have (in this case) a terms of trade deterioration, which means we either have to spend more to buy the same amount of imports, or buy less imports.
These examples are all good and well, but they do not tell us how many imports and exports have been bought. They just tell us who is able to buy more/less.
The key here is now elasticities. Surely, the PED for imports and exports is key to seeing how many will be bought or sold.
| Terms of Trade IMPROVEMENT | Reason | PED | Balance of Trade |
| Improve due to rising export prices | Exports are Inelastic | Improves. Continue selling roughly same amount for higher price |
|
| Exports are Elastic | Worsens. Sell far less at a higher price. | ||
| Improve due to falling import prices |
Imports are inelastic | Improves. Continue buying roughly same amount for lower price | |
| Imports are elastic | Worsens. Buy far more at a slightly higher price. |
| Terms of Trade DETERIORATION | Reason | PED | Balance of Trade |
| Worsen due to falling export prices | Exports are Inelastic | Worsens. Sell roughly same amount at a lower price. | |
| Exports are Elastic | Improves. Sell far more at a slightly lower price | ||
| Worsen due to rising import prices |
Imports are inelastic | Worsens. Buy roughly same amount at slightly lower price. | |
| Imports are elastic | Improves. Buy far less at slightly higher price. |
Overall Rules:
If Terms of Trade improve and imports or exports are inelastic, the Balance of Trade improves
If Terms of Trade improve and imports or exports are elastic , the Balance of Trade worsens
If Terms of Trade deteriorate and imports or exports are inelastic, the Balance of Trade worsens
If Terms of Trade deteriorate and imports or exports are elastic , the Balance of Trade improves
What this tells us:
If more exports are being sold, we know AD for that country will shift outwards and shows us economic growth.
If more imports are being bought, we know AD for that country will shift inwards and shows us less economic growth .
When we know the elasticities of imports and exports, and a country's terms of trade we will thus be able to work out the two aims stated at the beginning of this unit:
1) Whether or not a country is buying or selling more/less (global output)
2)
Which country is having to produce more (allocation of output)
Changing Terms of Trade Because the terms of trade is chiefly concerned with prices, anything that changes the prices of imports and exports, changes the Terms of Trade. Examples inculde: a) Exchange Rates
|
How to measure the Terms of Trade
This is very similar to the Retail Price Index
Set a base year
Give imports and exports a price index of 100 at the base year
Use the equation to work out current year’s price index for imports and exports
Give weighting to a selection of important imports/exports dependent on elasticity
Use the terms of trade equation to work out Terms of Trade
If values increase, this shows an improvement (prices of exports have increased relative to prices of imports)
e.g:
| Imports (price index) |
Exports (price index) |
|
| 2001 (base year) | 100 | 100 |
| 2002 | 102 | 100 |
| 2003 | 105 | 100 |
Terms of Trade and the Developing World
Before we go on to study Development Economics, we can see how the Terms of Trade act as an indication of how developing nations suffer. It has long been known that developing nations face deteriorating Terms of Trade. The reason? They are overly reliant on the export of commodities - prices for whom falls constantly, compared to imports. Let's see why.
1. Low Income Elasticity of Demand for their Exports
2 High Income Elasticity of Demand for Imports
3. Increases in world production and world productivity
4. No product variation