The Terms of Trade

1. Definition and Meaning

The terms of trade (TOT) measures the ratio of the average price a country receives for its exports relative to the average price it pays for its imports. It reflects the quantity of imports that can be purchased with a unit of exports.

KEY TAKEAWAY: The terms of trade is about the relative price of exports to imports, not the absolute prices.

2. Measurement of the Terms of Trade

2.1. Formula

The terms of trade is calculated using an index number:

2.2. Interpretation

• A TOT index above 100 indicates that export prices have risen relative to import prices since the base year (more favourable TOT).
• A TOT index below 100 indicates that export prices have fallen relative to import prices since the base year (less favourable TOT).

2.3. Example

If the index of export prices is 110 and the index of import prices is 100, then the TOT is:

This means that the country can buy 10% more imports with the same amount of exports compared to the base year.

VCAA FOCUS: VCAA often provides graphs of the TOT and asks students to interpret trends and analyse their effects.

3. Factors Affecting the Terms of Trade

3.1. Commodity Prices

• Increase in Commodity Prices: If a country is a major exporter of commodities (like Australia), a rise in global commodity prices will increase the price of its exports, leading to a more favourable TOT.
• Decrease in Commodity Prices: Conversely, a fall in commodity prices will decrease the price of its exports, leading to a less favourable TOT.

3.2. Production Costs in Trading Partners

• Increased Production Costs: If production costs rise in a country’s trading partners, the prices of its imports may increase, leading to a less favourable TOT (assuming export prices remain constant).
• Decreased Production Costs: If production costs fall in a country’s trading partners, the prices of its imports may decrease, leading to a more favourable TOT (assuming export prices remain constant).

3.3. Exchange Rates

• Depreciation of the Domestic Currency: A depreciation can lead to a more favourable TOT in the short term if export volumes don’t fall significantly, as exports become more competitive and imports become more expensive. However, the long-term effect depends on the elasticity of demand for exports and imports.
• Appreciation of the Domestic Currency: An appreciation can lead to a less favourable TOT in the short term as exports become less competitive and imports become cheaper.

3.4. Technological Change

• Technological advancements can lead to increased efficiency and lower production costs domestically, potentially increasing export competitiveness and improving the TOT.
• Technological advancements in other countries can lead to cheaper imports, which, if export prices remain stable, can worsen the TOT.

3.5. Global Economic Growth

• Strong global economic growth increases demand for a country’s exports, potentially leading to higher export prices and a more favorable TOT.
• Weak global economic growth reduces demand for a country’s exports, potentially leading to lower export prices and a less favorable TOT.

EXAM TIP: When analyzing factors affecting the TOT, clearly state whether the impact is on export prices, import prices, or both.

4. Favourable vs. Unfavourable Terms of Trade

COMMON MISTAKE: Students often assume a favourable TOT is always good. While generally positive, it can have complex effects, such as reducing international competitiveness if export prices become too high.

5. Effects of Movements in the Terms of Trade

5.1. Balance of Payments on Current Account

• Favourable TOT: Leads to an increase in the value of exports relative to imports, improving the trade balance and the current account balance (assuming volumes remain constant).
• Unfavourable TOT: Leads to a decrease in the value of exports relative to imports, worsening the trade balance and the current account balance (assuming volumes remain constant).

5.2. Living Standards

• Favourable TOT:
  • Increased National Income: Higher export revenues increase national income, leading to higher material living standards.
  • Increased Purchasing Power: Consumers can afford more imports, increasing access to goods and services.
  • Increased Government Revenue: Higher company profits from exports lead to increased tax revenue, which can be used to fund public services.
• Unfavourable TOT:
  • Decreased National Income: Lower export revenues decrease national income, potentially lowering material living standards.
  • Decreased Purchasing Power: Consumers can afford fewer imports, limiting access to goods and services.
  • Decreased Government Revenue: Lower company profits from exports lead to decreased tax revenue, potentially reducing the government’s ability to fund public services.

5.3. Domestic Macroeconomic Goals

• Economic Growth: Favourable TOT can stimulate economic growth by boosting export revenues and investment. Unfavourable TOT can dampen economic growth.
• Inflation: Favourable TOT can contribute to inflationary pressures if increased export revenues lead to increased demand. Unfavourable TOT can reduce inflationary pressures.
• Employment: Favourable TOT can lead to increased employment in export-oriented industries. Unfavourable TOT can lead to decreased employment in these industries.

STUDY HINT: Create diagrams illustrating the flow-on effects of a favourable and unfavourable TOT on the economy. This helps to visualize the complex relationships.