The Terms of Trade

A2 Macro

What are the terms of trade?

• The terms of trade measures the relative prices of the products that we export compared to the cost (prices) of the goods and services that we import

How do we measure the terms of trade?

• By dividing an index of export prices by an index of import prices

• If the terms of trade index goes up, we say that the terms of trade have improved

• If the index falls, we say that the terms of trade have deteriorated

Why does this matter?

• The terms of trade affect the gains from trading with other countries

• It also impacts on variables such as the balance of payments and living standards

Australia

Australia is heavily dependent on trade

For most commodities, Australian traders are price takers in global markets

Substantial trend improvement in the Australian terms of trade over the last ten-to-twelve years

Reflects the global commodity boom and appreciating Australian dollar

Improvement in terms of trade

Terms of trade now starting to move lower – mining boom is coming to an end

BrazilAnother country whose terms of trade is sensitive to world commodity prices and fluctuations in their exchange rate against the US dollar

Brazilian Export and Import PricesCharts show an index of export and import prices, January 2007 = 100

For Brazil, both export and import prices have risen

But the rise in the unit price of her exports has been faster than import price inflation

This has caused the Brazilian terms of trade to improve

Japan

Japan is an example of a country whose terms of trade have deteriorated over the last 10 – 15 years

What factors might explain this trend for Japan?

Consider the macro problems that have confronted Japan since the early 1990s

Worsening of the terms of trade

JapanWorsening of the terms of trade

Trend fall in the index of Japanese export prices

JapanWorsening of the terms of trade

Trend rise in the index of Japanese import prices

Terms of trade and the exchange rate

• The terms of trade ratio is heavily influenced by changes in the exchange rate

• A rise in the value of a country domestic currency decreases prices for its imports but also makes exports less competitive

• Thus a higher currency improves the terms of trade but might worsen the balance of trade

Significance of the Terms of Trade

Changes in the prices of the items we have to import

Standard of LivingAffects relative prices of capital

inputs needed to sustain growth

Prices of Imported Technology

Export and import prices affect the value of trade flows

Balance of Payments

Improved terms of trade might mean we are able to import cheaper food

Significance of the Terms of Trade

Changes in the prices of the items we have to import

Standard of LivingAffects relative prices of capital

inputs needed to sustain growth

Prices of Imported Technology

Export and import prices affect the value of trade flows

Balance of Payments

Improved terms of trade might mean we are able to import cheaper food

A weak exchange rate increases the prices of imports – worsens the terms of trade – e.g. makes imports of new technology more expensive

Significance of the Terms of Trade

Changes in the prices of the items we have to import

Standard of LivingAffects relative prices of capital

inputs needed to sustain growth

Prices of Imported Technology

Export and import prices affect the value of trade flows

Balance of Payments

Improved terms of trade might mean we are able to import cheaper food

A weak exchange rate increases the prices of imports – worsens the terms of trade – e.g. makes imports of new technology more expensive

Important not to confuse the terms of trade with the balance of trade!

More great study resources from tutor2u:

Economics Blog

A2 Macro Revision Notes