In this video we will do a basic introduction to the terms of trade.
I’ll show you what it means, how you calculate it and then we’ll take a look at a simplified
example.
The terms of trade measures the ratio of export prices to import prices.
Simply put, it looks at a basket of goods that we export and and import and tracks their
prices over time.
If export prices rise relative to import prices, there has been an improvement in the terms
of trade.
This means what we are earning is increasing relative to what we need to spend to import
the basket of goods and services.
If export prices fall relative to import prices, there has been a deterioration in the terms
of trade.
This means what we are earning is falling relative to what we have to spend to import
the basket of goods and services.
To illustrate what I mean, let’s do a quick calculation.
For the base year our terms of trade will always equal 100.
The formula is the index of export prices divided by the index of import prices times
100.
We use an index because we want to take a snapshot of a country’s exports and imports
to monitor changes over time.
It allows us to see whether exports are earning more or less revenue over time.
The same holds for imports; it allows us to see whether our imports are becoming more
expensive or cheaper over time.
In reality they will both be constantly changing, but we use the index to get a general picture.
As mentioned the base year terms of trade is always 100.
Assume now that in year 2 that same export basket sells for twice as much in the global
market.
If we are still able to buy the same goods in that import basket for the same price as
last year we have an improvement in our terms of trade from 100 to 200.
We can now buy twice as much as we did before given the increase in the amount we can earn
for the basket of exports used in the base year.
We can say that the terms of trade has improved from year 1 to year 2.
Suppose we exported only bananas and imported only oranges.
In the base year, for every unit of bananas sold we were able to earn enough to purchase
2 units of oranges.
This will be our starting point for comparison.
Next year we see an improvement in the terms of trade.
This would mean that the relative price of our bananas has gone up.
For some reason we are able to sell bananas at a higher price.
The price of oranges has remained constant.
Now that same unit of bananas can afford us three units of oranges.
All this means is that the increase in export prices has outpaced the increase in import
prices enough that we are able to afford more oranges given the difference between the two
sets of prices.
It doesn’t necessarily have to mean that bananas are more expensive and the price of
oranges are constant.
A worsening in the terms of trade would mean the revenue earned from exporting bananas
had fallen relative to the amount we had to pay for oranges.
In comparison to the base year and year 2, we are in a worse position.
This is because the revenue earned from selling one unit of bananas now only allows us to
purchase one unit of oranges.
Give this question a shot from CIE paper 1 in 2016 as published on the CIE website.
A country’s terms of trade increased from the base year value of 100 to 120 in the following
year.
What changes in export prices and import prices would have caused this?
Take a second to pause the video and try to pick the right answer.
When you click play, I’ll explain the correct choice.
Now that you have had some time to try it, you should have selected option C. Let me
explain why.
The terms of trade is equal to the index of export prices divided by the index of import
prices times 100.
The base year equals then 100 divided by 100 times 100 which gives us an index of 100.
If X times 100 equals 120 then x equals 1.2
This then means that our export prices have increased by 20%.
The only value that works is option C.
I hope you found this video on the measurement of the terms of trade helpful.
In the next video we will look at what causes changes in the terms of trade and the impact
it can have.
As always, if you have any questions or comments, please leave them below or email me at enhancetuition@gmail.com.
You can also tweet me @enhancetuition and visit me shortly on enhancetuition.co.uk.
For now, that’s us done and I will see you in the next one!