Terms of Trade

1. Terms of Trade November 2013

2. Explaining the ToT • The ToT is the ratio of the average price of exports to the average price of imports: • It is a measure of the amount of imports that can be exchanged per unit of exports.

3. 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.

4. 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 • Improvement in the ToT: an increase in the value of the ratio of average price of X to average price of M. It is a fall in the opportunity cost of imports. • Deterioration in the ToT: a decrease in the value of the ratio of average X prices to average M prices. It is an increase in the opportunity cost of imports.

5. ↑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.

6. Changes in the short-run • Changes in global demand due to: • Changes in consumer tastes • Changing needs of producers (demand for cereals) • Changes in global supply due to: • Restrictions in the availability of an input (oil) • Weather conditions • Changes in exchange rates: depreciation deteriorates the ToT, apreciation improves ToT. • Changes in domestic rate of inflation

7. Changes in the long term • Growth in incomes, affecting global demand: • Given low YED for food, prices of primary products rise less rapidly than prices of manufactured goods and of services: deterioration of ToT for countries that export primary products and import manufactured products. • Changes in productivity: • →Lower costs of production → shift S curve to right → ↓p • Technological advances (telecommunications, transport, agriculture,…). Same effect as productivity. • Trade protection

8. Trade protection: • Through trade protection, the US could decrease the global demand for cars and lower the price for car exporters. • Agricultural subsidies granted by the US and the EU have the effect of increasing global supply and decreasing world prices.

9. Effects on the current account • Balance of Trade = Value of X – Value of M • Balance of Trade = X revenues – M expenditures = pX X – pMM • A change in the ToT leads to an improvement in the balance of trade (smaller deficit or larger surplus) if it causes an increase in the value of X or a decrease in the value of M.

10. Changes in global demand • Increase: both p and q increase • Importer: ToT deteriorate and M expenditures increase, so Balance of Trade worsens • Exporter: ToT improve and BoT improve • Decrease: both p and q fall • Importer ….. • Exporter…. • ToT and B of Trade move in the same direction!

11. Changes in global supply • Change in S → p and q move in opposite directions: • Increase in Supply: p↓ and q↑ • Decrease in Supply: p ↑ and q ↓ • Effect on import expenditures and export revenues will depend on the PED for exports and imports.

12. If there is an increase in global supply: • Exporters: ToT deteriorate. Improve or worsen CA? If PEDX<1 → X revenues decrease → BoT worsens If PEDX>1 → X revenues increase → BoT improves • Importers: ToT improve. Improve or worsen CA? If PEDX<1 → M expend decrease→ BoT improves If PEDX>1 → M expend increase → BoT worsens • If PED <1 ToT and BoT change in same direction

13. Changes in exchange rates • Depreciation → Pm ↑ → deterioration ToT • If Marshall-Lerner condition holds the trade balance will improve. • Appreciation → Pm ↓ → improvement ToT • If Marshall-Lerner condition does not hold the trade balance will worsen.