The terms of trade is the ratio of the avergae price of exports over the avergae price of imports expressed as index numbers times by 100:
Index of exports prices / index of import prices x 100
Therefore, it measure the volume of imports that can be attained by a unit of exports.
Improvement: an increase in the terms of trade through time. This means that more imports can be bought per unit of export. This will occur if the average price of exports rise relatively to the price of imports.
Deteriation: a decrease in the terms of trade through time. This means that fewer imports can be bought per unit of export. This will occur if the average price of exports falls relatively to the price of imports.
Causes of changes in the terms of trade
In the short term:
Changes in demand conditions for exports and imports – if world demand for a counrty’s exports increases then its terms of trade will improve.
Changes in global supply of major resources, such as oil – if an oil exporting country increases its supply, then the price of oil will fall and the country’s terms of trade will worsen.
Changes in exchange rates – if a country experiences appreciation, then the price of its exports will rise so their will be an improvement in its terms of trade.
Changes in relative inflation rates – if a country experiences inflation, then the price of its exports will rise so their will be an improvement in its terms of trade.
In the long term:
Increased productivity – government spending aimed at increases long run aggregate supply, may lower costs to firms and therefore reduce domestic consumer prices. Therefore improving the terms of trade.
Changes in world income levels – as incomes rise more is spent on secondary and tertiary goods, rather than primary goods, so this increases the terms of trade for more industrialised countries but worsens the terms of trade for developing countries exporting primary goods.
Imporved technology – this can increase efficiency and therefore lower firms’ costs, so consumer prices fall. This means that the country’s terms of trade improve.
Consequences of changes in terms of trade
If the price of exports rises, so the terms of trade improve, and these exports are price elastic, then there will be a significant decrease in the quantity demanded by foreign consumers. However, if the price for these exports falls then there will be a large increase in the quantity demanded by foreigners.
If PED is inelastic and export prices rise, then there will be a much smaller decrease in the quantity demanded by foreign countries. If the prices fall, there will be a very small increase in demanded by foreign countries.
Supply for primary commodities has general grown, due to technological progress in extraction techniques, whilst demand has tended to remain the same, as they are usually demand price inelastic goods. This has worsened the terms of trade of devloping countries that specialise in these goods because the prices have fallen due to the increased supply. Therefore, this may contribute to the world distribution of income becoming more unequal.
In addition, in the short term developing countries suffer because the supply of commodities tends to be price inelastic, due to the relience on good weather conditions, difficulty in storage and immobility of factors of production. Therefore, prices are often quite volatile which increases uncertainty in the developing countries’ economies so foreign investment falls.