(a) With reference to Figure 1, calculate the annual CPI inflation rate for China in October

2014. (5)
Knowledge 1, Application 2, Analysis 2

Knowledge/understanding:
 CPI is a weighted average (1)

Application:
 Contribution from food items = 2.5 x 0.318 (1) = 0.795
 Contribution from non-food items = 1.2 x 0.682 (1) = 0.818

Analysis:
 0.795 + 0.818 (1) = 1.6% (1)
NB Accept 1.6% to 2%.
 Starter
Pair discussion

In 2014, the world price of crude oil

approximately halved. For a few
countries around the world, like
Venezuela and Saudi Arabia, oil
exports account for the vast
majority of all their exports. For
these countries, what happens to
the amount of imports they can buy
with each barrel of oil exports? Are
the better or worse off?
4.1.4 Terms of Trade
 Lesson Questions
1. What is meant by ‘ terms of trade’?
2. Can you calculate terms of trade?
3. Can you explain how each of the following factors would
cause terms of trade to change:
• Relative inflation rates?
• Relative productivity rates?
• Changes in exchange rates?
4. Can you explain the impact of changes in a country’s terms of
trade?
 What is ‘terms of trade’?
We know that countries can gain as well as lose from trade, but what determines who
gains from international trade?

Answer: terms of trade

Why is it useful to know terms of trade?

Tells us the quantity of exports that need to be sold to purchase a given amount of imports.
This is useful for LEDCs than can use export revenue to purchase imported capital
equipment, in order to boost growth and development
 Terms of Trade - definition

What Are Terms of Trade (TOT)?

Terms of trade (TOT) represent the ratio between a country's export prices and its
import prices. In other words, how many units of exports are required to purchase a
single unit of imports? The ratio is calculated by dividing the price of the exports by
the price of the imports and multiplying the result by 100.

When more capital is leaving the country than is entering into the country, then the
country’s TOT is less than 100%. When the TOT is greater than 100%, the country is
accumulating more capital from exports than it is spending on imports.
 What is ‘terms of trade’?
Terms of trade measure the price of country’s exports relative to the price of its imports.

Simply put, the ratio of average export prices to average import prices

Index of terms of trade = index of export prices X 100

index of import prices

NB: terms of trade is measured as an index because it is calculated from the weighted
average of many different types of exports and imports e.g. value of oil and cars. As oil
from the North Sea would be more valuable as an export than Bentley cars, a change in
the price of oil is more important when calculating the average prices of exports than a
change in the price of Bentleys. Hence, the larger the proportion, the greater the effect on
an average.
 Can terms of trade change?
Imagine that price of both exports and imports is
rising, but export prices are rising at faster rate
than import prices. What would happen?
Improving terms of trade
• If a country can buy more imports with a
given quantity of exports, its terms of trade
have improved.
• Since the price of exports increase more
rapidly, the monetary value of the basket of
exports rises and can buy more imports
• for the same physical quantity of exports
(copper, rubber, oil etc.) as before, a country
could buy more consumer and capital goods
from abroad
Imagine that price of both exports and imports is
rising, but import prices are rising at faster rate
than export prices. What would happen?
Deteriorating terms of trade
• Ratio of exports to import prices will fall
• Since the price of exports is rising more slowly,
the monetary value of the basket of exports
can buy fewer imports than before
• Fall in the terms of trade shows that the same
volume of exports will purchase a smaller
volume of imports than before
• A country must export a greater volume of its
goods in order to acquire/finance the same
volume of imports
 Can terms of trade change?
Imagine that price of both exports and imports is
falling, but import prices are falling at faster rate
than export prices. What would happen?
Improving terms of trade
• A country can buy more imports with a
given quantity of exports because its terms
of trade have increased.
• Since the price of imports falls more rapidly,
relatively the monetary value of the basket
of exports rises and can buy even more
imports than before
Imagine that price of both exports and imports is
falling, but export prices are falling at faster rate
than import prices. What would happen?
Deteriorating terms of trade
• Ratio of exports to import prices will fall
• Since the price of exports is falling more
rapidly, the monetary value of the basket of
exports can buy much fewer imports than
before
• The same volume of exports will purchase a
small volume of imports than before
• A country must export a greater volume of its
goods in order to acquire/finance the same
volume of imports
 Calculating terms of trade
Table 2 Index of export prices and index of import prices (Year 5=100)
Year 1 2 3 4 5 6
Index of export prices 105 99 95 97 100 110

Index of import prices 110 107 105 102 100 105

Index of terms of trade

a. Table 1 shows the index of export prices and the index of import prices for a country
over six years. Calculate for each year the index of terms of trade in the bottom row.
b. Between which years is there:
Example
i. An improvement and?
ii. A deterioration in the terms of trade? =Year 1 index of export prices X 100
Year 2 index of import prices
Index of terms of trade = index of export prices X 100 =105 x 100
110
index of import prices = 95.5
 Factors affecting terms of trade
Exchange rate Inflation

What factors do you think Tariffs

can cause the terms of
trade to change?

Productivity

Incomes
 What is the impact of changing terms of trade?
A change in terms of trade will have an impact of the following:
• Living standards
• Competitiveness
• Balance of payments on the current account
• Output
• Employment
 Example chain of reasoning for impact of changing terms of trade
One impact of improving terms of trade is a rise in unemployment.

This is because the improvement in the terms of trade is caused by a rise in export prices relative to import prices.

As exports may appear relatively more expensive, this may lead to a fall in the volume of exports sold and a decline in spending
on exports.

Therefore, with a contraction in the output of exports, the net trade deficit may increase, reducing AD, real GDP and thus the
economy may slow down. Ultimately, exporting firms may respond by reducing the size of their workforce.
Example chain of reasoning for impact of changing terms of trade
One impact of improving terms of trade is a fall in unemployment.

This may be due to the improvement in the terms of trade is caused by a fall in import prices relative to export prices.

As imports may appear relatively cheaper, this may lead to an increase in the volume of import sold, which would lead to a fall in SRAS
and AD (extra development), reducing the average price level.

If there are few substitutes for imports, then PED for imports would be inelastic. Then consumers are not as likely switch and the
increased spending on imports may not be of a greater proportion. Thus domestic producers are less likely to lose market share and
reduce their output. As a result unemployment may not rise.
 Impact of changes in terms of trade and current account
If exports are price elastic, then an increase in export
prices will lead to a larger proportionate fall in the
quantity of exports. Consumers are very sensitive and so
they are more likely to switch to buying foreign imports.
So the value of exports (PxQ) is more likely to decrease.
Assuming the price of X rises faster than the price of M,
ToT improve. However, what effect does the price
increase have on the current account deficit?
Price of
exports Answer: ToT improves but
current account deficit worsens
P2
↑M > ↑X
P1
D1
If exports are price inelastic, then an increase in export
prices will lead to less than proportionate fall in the
quantity of exports. Consumers are not sensitive and so
they are less likely to switch to buying foreign imports. So
the value of exports (PxQ) is more likely to increase.
Assuming the price of X rises faster than the price of M,
ToT improve. However, what effect does the price
increase have of the current account deficit?
Price of
Answer: ToT improves AND
exports
current account improves
P2
↑X > ↑M
P1

D1

QD2 QD1 QD2 QD1 Quantity of exports

Quantity of exports
 Impact of changes in terms of trade and current account
If imports are price elastic, then an increase in import prices If imports are price inelastic, then an increase in import
will lead to a larger proportionate fall in the quantity of prices will lead to less than proportionate fall in the
imports demanded. Consumers are very sensitive and so quantity of imports demanded. Consumers are not
they are more likely to switch from buying foreign imports. sensitive and so they are less likely to switch from buying
So the value of imports (PxQ) is more likely to fall. Assuming foreign imports. So the value of imports (PxQ) is more
the price of M rises faster than the price of X, ToT likely to increase. Assuming the price of M rises faster than
deteriorate. However, what effect will the price increase the price of X, ToT deteriorate. However, what effect will
have on the current account?
this have on the current account?
Price of Answer: deterioration in terms of Price of
trade and improvement in current exports Answer: deterioration in terms of
imports
account trade and deterioration current
P2 ↓M > X ↑ P2
account deficit
P1 P1 ↑M > X ↓
D1

D1

QD2 QD1 QD2 QD1 Quantity of imports

Quantity of imports
Impact of changes in terms of trade and current account

Elasticity Price change Terms of trade Current account

balance
Exports PED Rise↑ Improve Deteriorate
Elastic Fall ↓ Deteriorate Improve
PED Rise↑ Improve Improve
Inelastic Fall ↓ Deteriorate Deteriorate
Imports PED Rise↑ Deteriorate Improve
Elastic Fall ↓ Improve Deteriorate
PED Rise↑ Deteriorate Deteriorate
Inelastic Fall ↓ Improve Improve
 Chains of reasoning - terms of trade

This short exam technique video looks at building chains of reasoning to answer
a question:

Explain two economic effects of an improvement in the terms of trade.

https://www.tutor2u.net/economics/reference/chain-of-reasoning-the-terms-of-trade
 Review questions
1. Can you define terms of trade?
2. Can you recall the formula for index terms of trade?
3. Can you calculate the index terms of trade using the information on the table
below? Date Price index of exports Price index of imports
2000 72.1 74.4
October 2014 94.8 95.7

4. Can you outline 3 factors that cause terms of trade to change?

5. Can you explain how PED and terms of trade affect the current account balance
of payments?
 Exam questions

Q1. Between 2000 and 2013, Bangladesh’s terms of trade worsened by around 43% while
Norway’s terms of trade improved by around 60%. (WEC04, JAN 2018)

(a)Assess the factors that can cause a change in a country’s terms of trade. (15)

(b)Evaluate the effects of a worsening of a country’s terms of trade on a government’s

macroeconomic objectives. (25)

Q2. With reference to Figure 1, explain what is meant by the terms of trade. (4) (WEC04, OCT
2017)

Q3. With reference to Figure 4, analyse two likely economic effects of the trend in Japan’s
terms of trade. (8) (6EC04, JUN 2014)