Download Terms of Trade - AKM Fahmidul Haque

Terms of Trade
Understanding the Terms of Trade (ToT)
• The ToT is the ratio of the average price of exports to
the average price of imports:
average price of exp orts
ToT 
average price of imports
• It is a measure of the amount of imports that can be
exchanged per unit of exports.
• Assume that Finland and Russia trade only mobile
phones (Finland) and caviar (Russia):
One mob phone = USD 300
One hectogram caviar = USD 100
ToT Finland = 300/100 = 3 → One phone buys 3
hectograms caviar
ToT Russia = 100/300 = 0.33 → One hect caviar will buy
0.33 mob phones.
• Suppose price of caviar ↑ to USD 200:
ToT Fin = 300/200 = 1.5 (↓) Deterioration of ToT
ToT Rus = 200/300 = 0.66 (↑) Improvement of ToT
• The distribution of global output has changed in favour of
Russia, which can now get more imports for a given
amount of exports (or the same quantity of imports for a
smaller amount of exports). We then say that Russia’s
ToT have improved.
• The opposite holds for Finland, which can now get fewer
imports for the same amount of exports. Finland’s ToT
have deteriorated.
• Since ToT = Average PX / Average PM, then:
• ↑Price M or ↓Price X → Deterioration ToT
• ↓Price M or ↑Price X → Improvement ToT
• We cannot always conclude Improvement
(Deterioration) of ToT makes a country to be
better (worse) off. This depends on the causes
of changes in the ToT.
ToT and the Balance of Trade
• Balance of Trade = Value of X – Value of M
• With only two goods being exported and
imported:
– Value of X = X revenues = p1q1+p2q2
– Value of M = M expenditures = p3q3 + p4q4
• Therefore, a change in ToT resulting from a
change in PM(PX) will affect the value of imports
(value of exports).
Consequences of changes in de ToT for the
Balance of Trade / Current account
• A country will gain from a change in its ToT if it
can ↑ its X revenues or if it can ↓ its M
expenditures. In both cases CA improves.
• IMPORTANT: whether an improvement in the
ToT leads to an improvement of the CA depends
on the PED for exports and imports.
• From Micro theory we know:
– Elastic Demand (PED>1): ↑P → ↓TR, ↓P → ↑TR
– Inelastic Demand (PED<1): ↑P → ↑TR, ↓P → ↓TR
• Imports:
– Elastic Demand (PED>1): ↑P → ↓M exp, ↓P → ↑M
exp
– Inelastic Demand (PED<1): ↑P → ↑M exp, ↓P → ↓M
exp
• Exports:
– Elastic Demand (PED>1): ↑P → ↓X rev, ↓P → ↑X rev
– Inelastic Demand (PED<1): ↑P → ↑X rev, ↓P → ↓X
rev
• Improvement of ToT (caused by ↑PX or ↓PM):
– If PED for X or M is larger than 1→ deterioration CA
– If PED for X or M is smaller than 1→ improvement CA
• Deterioration of ToT (caused by ↑PM or ↓PX):
– If PED for X or M is larger than 1→ improvement CA
– If PED for X or M is smaller than 1→ deterioration CA
Causes of changes in ToT
1. Changes in exchange rates
2. Changes in demand for an export product:
price and quantity move in the same
direction→ effects on CA independent of PEDs
3. Changes in supply of an export product: price
and quantity move in opposite directions→
effects on CA depend on PEDs
Changes in exchange rates
• Depreciation/Devaluation of dom. currency →
↓ToT.
– If PED > 1: Improvement of CA
– If PED < 1: Worsening of CA
• Appreciation/Revaluation of dom. currency →
↑ToT.
– If PED > 1: Worsening of CA
– If PED < 1: Improvement of CA
Changes in Demand for an X product
• Increase in foreign D for an X product: D shifts
right → both Q exported and Price ↑ and X
Revenues increase regardless of PEDs. Hence,
CA improves
• Decrease in foreign D for an X product: D shifts
left → both Q exported and Price ↓ and X
Revenues decrease regardless of PEDs. Hence,
CA worsens
Increases in Supply of an X product
• Technology improvements or increases in productivity
shift S rightwards → ↑QX +↓PX:
– If PED > 1 → ↑X Rev → Improvement of CA
– If PED < 1 → ↓X Rev → Worsening of CA
• Most manufactured goods are price elastic, so
technology advances do not pose a problem and a lower
price increases international competitiveness
• Many primary (dus including agricultural) products are
price inelastic. For exporters technology advances or
productivity increases may lead to ↓X Rev and
worsening of CA
Decreases in Supply of an X product
•
S can shift to the left for two reasons:
1. A restriction in the S of exports (eg: OPEC)
2. An increase in wages domestically leading to costpush inflation → ↑P of exported good
Therefore:
– If PED < 1 → ↑X Rev → Improvement of CA
– If PED > 1 → ↓X Rev → Worsening of CA
•
Benefits of cost-push inflation will be only shortterm, as Gov will counteract negative effects in
the economy (inflation and recession) with
monetary and fiscal policies.
• However, oil exporters which restrict their S of oil
benefit from long lasting effects on their CA, as
oil has a low PED for exports (↑P→ ↑X Rev). In
particular, OPEC countries have accumulated
large surplusus in their CA.
• On the contrary, oil importers have a low PED
for imports of oil: ↑P→ ↑M Exp
Consequences of long-term changes in the
ToT for the domestic economy
• These changes are more important for
developing countries, specially if their
production is mainly focused on a few
commodities for export.
• This makes these countries more vulnerable: if
prices of these commodities experience longterm trends in one direction or wide and abrupt
fluctuations over short periods of time, effects
are felt more strongly.
• Long term improvements in ToT redistribute
global output and income towards the country
experiencing the improvement.
• This allows increased investment and increased
imports of capital goods, which can have a
positive impact on economic growth.
• Impacts within the domestic economy:
– If increase in X prices: it is likely to be lasting if
caused by a long-term increase in D for X. This will
favour technological change, increased employment
and greater investment.
– If decrease in M prices: will impact consumers and
firms (lower prices in consumer or capital goods)
• Long-term deterioration in ToT redistributes
global output and income away from the country
experiencing the deterioration.
• Increasing quantitites of exports are needed in
order to maintain a certain amount of imports.
• Reduces possibilities for investment and
diminishes the quantity of imports needed for
production
• Empirical research shows that developing
countries which are non-oil commodities
exporters have experienced deteriorating ToT
over long periods of time.
Figure 1 - A. Real agricultural commodity price trends (1980 = 100)
(deflated by the price index of manufactured exports of industrial
economies)
On average, prices of key agricultural commodites fell by 50%
between 1980 and 2000.
•In the case of certain products, including sugar and cotton the fall has
been even greater.
Long term deterioration in ToT in developing
countries
Causes
1. Primary products .
– As Y↑, in relative terms, a lower fraction of the
increase is spent on primary products and a higher
fraction on manufactured products. D for prim
products has slower growth and prices of these
products tend to fall relative to prices of
manufactured products.
– Food has a low PED
– Some non-food primary products (rubber, cotton) face
competition from synthetic alternatives, leading to low YED for
these products, which puts downward pressure on the prices.
2. Technological advances in agriculture. Slow demand
growth and increased supply have caused prices to
decrease even further.
3. Protection of agriculture in DCs. In order to protect
farmers’ income, governments in DCs:
– impose tariff and other trade barriers on imports of agricultural
commodities, which restricts world D for protected agricultural
products
– grant export subsidies, which increase world supply
Effect is ↓p.
4. High YED for imports in developing countries:
– Wealthy consumer groups spend on manufactured luxury goods
– Western products becoming popular in LDCs (eg Coca-Cola
and brand-name clothes)
→Large D growth for high-priced imports
5. Impacts of increased productivity
– In DCs: increased wages (low UE, powerful labour unions).
Instead of an increase in supply of manufactured goods
(rightward shift of S), productivity increases cause a decrease in
S. Depending on which effect is larger, P could ↑.
– In LDCs: always decrease in prices (high UE, weak labour
unions).
Therefore: P of manuf goods tend to ↑ and P of primary pdts tend
to ↓.
6. Oligopolistic mkt structures in more DCs
– Manufactured goods in DCs often produced by
oligopolistic firms with more mkt power
– Primary pdts in LDCs produced in more competitive
mkts, with low degree of mkt power.
Impacts of deteriorating ToT in LDCs
• Countries which export mainly commodities:
falling X rev and decline (or weak increase) of Y
and output.
• This has negative effects on agricultural UE,
investment, farm incomes and rural poverty.
• It also seriously worsens BoP, as well as
• Growth and development performance