Transcript The Terms of Tradex

The Terms of Trade
A2 Economics
• David Ricardo’s theory of comparative advantage explains that if
countries specialise in the production of the good/service in which
they have a comparative advantage, then all countries can move
outside their PPF and gain from trade. How the gains from trade
themselves are distributed depends on the actual terms of trade.
• The price of a country’s exports relative to the price of its imports.
• We calculate the terms of trade as an index number using the
following formula:
• Terms of Trade Index (ToT) = 100 x Average export price index /
Average import price index
• If a country can buy more imports with a given quantity of exports, its terms of trade have
improved. For example, during the commodity price boom, many resource-exporting
developing countries experienced increases in their terms of trade. In other words, for the
same physical quantity of exports (copper, oil etc.) as before, they could buy more consumer
and capital goods from abroad
• If import prices rise faster than export prices, the terms of trade have deteriorated. A greater
volume of exports has to be sold to finance a given amount of imported goods and services.
Typically this leads to a fall in the standard of living because imports of food and
technologies are more costly
• The terms of trade fluctuate in line with changes in export and import prices. The exchange
rate and the rate of inflation can both influence the direction of any change in the terms of
trade
• A key variable for many developing countries is the world price received for primary
commodity exports e.g. the world export price for Brazilian coffee, raw sugar cane, iron ore
and soybeans.
The chart below tracks what has happened to the
terms of trade for Brazil in recent years.
• Brazil is a commodity exporter – her terms of trade are sensitive to world commodity
prices
• After a period of time when the Brazilian terms of trade was declining (1998 through to
2005) the economy then saw a steep increase in the terms of trade index rising from to
125 in 2010
• High and rising demand for commodities from Asia—China is now Brazil’s largest trading
partner— drove Brazilian export prices to record highs and a strong improvement in her
trade surplus in many primary products.
• Commodity prices jumped by 75% in real terms between 2001 and 2010, a period during
which Brazil’s terms of trade improved by 34%
• This has had some second-round consequences damaging for the rest of her economy.
One effect has been to cause the Brazilian currency (the Real) to appreciate which has
damaged the price competitiveness of many of Brazil’s manufacturing businesses such as
steel and vehicle making.
The chart below tracks what has happened to
the terms of trade for Nepal in recent years.
• Nepal joined the World Trade Organisation in 2004 and in global terms her
exports account for only 0.01% of total world trade. Crucially 70% of her exports
are manufactured products and 66% of total exports flow to India (the next
highest is 11% to the European Union).
• Our chart above shows that the Nepalese terms of trade has declined in nearly
every year since 2002. A key reason for this has been a trend decline in world
prices of manufactured products – a trend linked directly to the effects of
globalisation. Nepal is an extremely small economy with little pricing power in
world markets. It must compete with huge-scale manufacturers in China and
India which puts pressure on Nepalese businesses to reduce their prices to
remain competitive in the international market.
• Another factor causing the terms of trade in Nepal to fall further has been the
high cost of imports of essential imports including food and energy which by
definition will have a low price elasticity of demand. Our chart below shows the
extent of the increase in the value of imports coming into Nepal since 2001.
Case study
• Over time, fluctuations in the price of a good or service that
dominates a country's exports will have a significant impact on that
country's terms of trade. This can be seen in Fig. 3.2 where the
steady growth in world output from 2001–2008 led to an increase in
the (derived) demand for copper, an increase in price and an
improvement in Zambia's terms of trade. During the financial crisis
demand (and copper prices) fell, leading to a fall in price which has
since been followed by an erratic recovery.
Case study
• Analyse the advantages Zambia has enjoyed as a result of the terms
of trade improving
• Analyse the disadvantages Zambia may have encountered as a result
of the terms of trade improving
• What are the trends/reasons for trends seen in the diagram. What do
you see as the long run trend? – extrapolate the data
Prebisch-Singer Hypothesis
• Video
Prebisch-Singer Hypothesis
• The argument that countries exporting primary commodities will face
declining terms of trade in the long run, which will trap them in a low
level of development as more and more exports will need to be sold
to ‘pay for’ the same volume of imports or secondary sector or capital
goods
• Movements in the terms of trade reveal nothing about the volume of
exports and imports which determine the effect on the balance of
payments and AD
• While rising export prices may lead to a favourable gain, much
depends on the PED for the good or service
• Definition test Monday
• Page 240-254 (26 definitions!)
The pattern of global trade
• International trade
Trading Blocs – intra-regional trade
Key terms
• Developed economies
• Developing economies
• Liberalisation
• Transition economies
• Inter-industry trade
• Intra-industry trade