4.1.4 - Terms of trade

• The terms of trade measures the rate of exchange of one product for another when two countries trade
• Calculation of terms of trade:

  • (average export price index/average import price index) x100
• Factors influencing a country’s terms of trade:

  • In the short run, exchange rates, inflation and changes in demand/supply of imports or exports affect the terms of trade since these affect the relative prices of imports and exports
• Factors influencing a country’s terms of trade:

  • In the long run, an improvement in productivity compared to a country’s main trading partners will decrease the terms of trade since export prices will fall relative to import prices. This can be caused by new technology, more efficient labour
• Impacts of changes:

  • If PED of exports and imports is inelastic, a favourable movement in terms of trade would improve the current account on the balance of payments whilst if it is elastic, a favourable movement would worsen the current account.