In this video we will be looking at the causes and impact of changes in the terms of trade,
both in the short-run and long-run.
Firstly, we will look at the causes of changes in the terms of trade, specifically short-run
causes.
When examining the short run, the focus is on three key areas including changes in the
supply and demand for exports and imports, changes in the exchange rate and changes in
the relative price level.
As the demand and supply changes for exports and imports, this will affect their price
and consequently the terms of trade.
For example, if a country is reliant upon the primary sector for export trade it can
be adversely affected when the world price for commodity exports fall.
This could be due to a significant drop in demand by a major importer.
Again, price fluctuations can have either a positive or negative impact on an economy
that is heavily focused on activity in the affected sector.
With particular regards to the article shown above in reference to the fall in global prices
for industrial metals, this can be attributed to the reduction in demand for housing in
China.
To quote from the article:
Slowing housing prices in China is fanning concern of another steel glut, which is weighing
on base metals, according to Ryan McKay, a commodities strategist at TD Securities.
“Less construction demand means less demand for housing, means less demand for steel and
less demand for all the base metals that go into steel,” he said by telephone from Toronto.
“Demand expectations have been pretty high, so if that starts to trail off you’re going
to see these metals tail off a little bit.”
Whichever factors affect the exchange rate will have an impact on the terms of trade.
As a country’s currency appreciates and depreciates, it influences the relative prices
of imports and exports.
If a country’s price level rises, its exports will become more expensive.
In the short-run, this will improve their terms of trade as the goods they sell are
increasing in price.
Per the graph above, if American exports suddenly increase in price due to inflation this raises
their index of export prices.
Assuming all else is constant, this will improve their terms of trade.
In the longer term, changes in the terms of trade are likely to be determined by those
factors which exert a long term influence on the demand for, and supply of, a country's
exports and imports.
As global incomes rise, it will drive the demand for exports up.
Depending on a nation’s exports, it may increase the price of their goods and services.
Economies dependent on the primary sector will be affected differently to an economy
with a stronger tertiary sector.
An increase in domestic productivity will increase the supply of a good and thereby
its price.
By increasing productivity, a nation may experience a deterioration in their terms of trade.
Improvements in technology may also have a similar effect to increases in domestic productivity.
Technology used to make production more efficient will also increase productivity and lower
per unit costs.
This increases supply and decreases the price of exports.
This, too, will cause the terms of trade to deteriorate.
The hypothesis puts forth the argument that the price of primary commodities falls relative
to the price of manufactured goods in the long term.
This in turn, causes the terms of trade of economies heavily focused on primary products
to deteriorate.
It is argued that manufactured goods have a greater demand responsiveness to changes
in income, or greater income elasticity, than primary products.
As incomes rise, the demand for manufactured goods, such as cars, cell phones and other
various items increases more rapidly than the demand for primary products.
Also, primary products tend to have a low price elasticity of demand, so as their prices
decline this results in a reduction in total revenue as opposed to an increase.
As the terms of trade either improve or deteriorate for a nation, this will clearly have an impact
on the economy.
We’ll next examine what is likely to happen following a significant change of the terms
of trade.
If a country’s terms of trade improves, meaning less exports need to be sold to buy
a given amount of imports, then it is likely that the standard of living will improve.
However, with higher export prices, a nation’s goods and services may become less competitive
overseas and this could actually result in less export revenue, reduced output and increasing
unemployment.
The extent of the change is largely dependent upon the elasticity of demand for exports.
The inverse can also be argued.
If a country’s terms of trade deteriorates, meaning more exports need to be sold to buy
a given amount of imports, then it is likely that the standard of living will decrease.
It is overly simplistic to argue that an improvement in the terms of trade will necessarily lead
to an increase in the standard of living.
One must also consider the elasticities of exports and imports to accurately picture
what will happen within an economy as prices change.
This topic tends to be a more difficult one for students so if you’ve understood, or
mostly understood this presentation, you’re doing well.
If you have any questions or comments, please write them in below or email me at enhancetuition@gmail.com.
You can also tweet me @EnhanceTuition and visit me at www.enhancetuition.co.uk for more
resources.
That’s us done for now and I will see you in the next one!