HL extensions Definition, measurement and calculation of terms of trade Improvement and deterioration of terms of trade Short term influences on the terms of trade Long run influences on the terms of trade

Intro questions:

How would a depreciation of the Canadian dollar affect USA and Mexico’s terms of trade?

How might a deterioration of a country’s terms of trade lead to inflation?

Why might an improvement of the terms of trade have negative effects for an economy?

How have deteriorating terms of trade affected the majority of less developed countries during the past 40 years.

Chapter 76 & 77: HL extension – Terms of trade (3.5)

Definition, measurement and calculation of terms of trade

Definition: “Terms of trade index “The terms of trade index is the (indexed) average price of exports over the (indexed) average price of imports at a given point in time (tn). A decrease in the terms of trade index shows a deterioration of the terms of trade.

Index of the average price of exports at tn

Index of the average price of imports at tnx 100 Index of ToT at tn =

Calculate the missing values in the table. Explanation forthcoming under next heading.

2007 2008 2009 2010Av price of X   112 119 123Av price of M   115 x 125Index of ToT 100 x 101.7 x

Improvement and deterioration of terms of trade The index in figure 76.1 shows how the terms of trade for China have deteriorated by 20% over a 10 year period.

(Source: World Bank at www.worldbank.org)

However…do not confuse ‘improved’ with better or ‘deteriorated’ with worse! An improvement in the terms of trade means that the Home economy gets more imports for exports – but it also means that trade partners get less for their exports. In the same way, a deterioration in the terms of trade mean that Home country exports are actually cheaper – this might lead to an improvement in current account in the balance of payments.

Short term influences on the terms of trade The terms of trade change over time. In the short run, a number of influences will cause a change in the terms of trade:

Perhaps the most obvious influence on the terms of trade is a change in the exchange rate – indeed this is the most likely reason for the decline in China’s terms of trade over the past decade as China has strived to keep the Yuan rate low. Depreciation of the home currency worsens the terms of trade while depreciation of trade partners’ currencies improves home’s terms of trade.

Increased demand for a country’s exports will improve the terms of trade –due to both the exchange rate effect and the price effect on export goods. Increased supply of exported goods will lower the terms of trade – especially goods which are demand inelastic in price.

It is possible to intentionally alter the terms of trade by the use of trade barriers, intervention purchasing/selling of the home currency and devaluation.

A booming economy can attract investment funds and cause the currency to appreciate and thus the terms of trade to increase. It is also possible that demand pull inflation causes depreciation and a deterioration of the terms of trade.

Long run influences on the terms of trade In the long run, there are a number of fundamental factors which will have an impact on the terms of trade:

Increased investment and supply-side policies which increase long run aggregate supply can lower domestic prices relative to trade partners. Increased productivity would have the same effect.

Increased world supply and market ‘gluts’ can depress the market for a country’s exports. This happened to a number of coffee and oil producing nations during the 1980s and ‘90s.

Increasing incomes will shift demand towards secondary and tertiary goods with higher income elasticities, increasing the terms of trade for industrialised countries and decreasing the terms of trade for countries dependent on exports of primary goods.

Purchasing power parity theory (see Chapter 67) predicts that exchange rates will ultimately adjust to different inflation rates in trading countries. Since the terms of trade are strongly linked to exchange rates, PPP adjustment of exchange rates will naturally affect the terms of trade.

Chapter 77: HL extension – Consequences of a change in the terms of trade (3.5)

HL extensions Terms of trade and redistribution effects Terms of trade, PED and the balance of payments Terms of trade, commodities and LDCs

Redistribution effects EFFECTS OF AN IMPROVEMENT IN THE TERMS OF TRADE

Good: Perhaps the most obvious effect is that a country which has improved its terms of trade will be able to consume more imports and thus experience a general increase in living standards. Another effect of being able to get more for domestic goods is that external debt servicing (i.e. paying off loans and interest) will be easier. Firms will also be able to import cheaper raw materials and capital, which can enhance competitiveness.

Improved terms of trade can also improve the current account in the balance of payments. If exports are relatively inelastic, an improvement in the terms of trade can increase export revenue and improve the current account, since the relative increase in price will be greater than the relative fall in the quantity of export goods sold. The same holds true if imports are demand inelastic; import spending would decrease.

Bad: As you may have guessed, if exports are demand elastic then an improvement in the terms of trade will cause export revenue to fall – just as import spending would rise if the demand for imports is relatively elastic. Both would have a negative effect on the balance of payments. A decrease in export revenue and/or an increase in import spending could lower national income and adversely affect employment.

EFFECTS OF A DETERIORATION OF THE TERMS OF TRADE Good: A decrease in the price of exports relative to the price of imports will lead to an improvement in current account if the price elasticity of demand for exports is elastic. If the demand for exports is also price elastic then export revenue will increase and also improve the current account balance. Increased demand for exports and/or decreased demand for imports will increase aggregate demand and perhaps increase job opportunities.

Bad: Higher prices of foreign goods will not only lower consumption possibilities for households, but increase foreign debt burdens and make imported factors dearer. A deterioration of the terms of trade will have a negative effect on the current account if the demand for export goods is price inelastic, as total export revenues will fall. Inelastic demand for imports will also be negative for the current account, as total import spending will rise.

Q/t

P ($)

DImports of secondary goods

S0

Price fluctuations of secondary goods

S1 S2

DImports of primary goods

Price fluctuations of primary goods

100

I: Primary goods exporters

Q/t

P (index in constant USD) S0 (exports)

S1 (exports)

Q0 Q1

Dprimary goods

Q/t

P (index in constant USD)

Q0 Q1

P1, secondary goods

P1, primary goods

II: Secondary goods exporters

The price of primary goods falls relative to secondary good; the terms of trade for primary goods exporters has worsened. ∆↓export revenue > ∆↑ export

revenue; ∆↓current account ∆↓export revenue < ∆↑ export revenue; ∆↑current account

S0 (exports)S1 (exports)

60

10080

Dprimary goods

Ugly: See terms of trade for developing countries further on.

Terms of trade, PED and the balance of payments As shown in Chapter 9 (Applied economics; commodity price fluctuations), primary good prices will fluctuate a great deal more than prices for secondary goods.

PED, TERMS OF TRADE AND BALANCE OF PAYMENTS As the relative price of primary goods fallen more than that of secondary goods, primary good exporters have had a worsening in their terms of trade.

LOW YED AND FALLING PRIMARY GOODS PRICESHere is how low yED for primary goods causes falling prices for commodities in the long run:

Low income elasticity of demand for primary goods in more developed nations (MDCs) means that even though MDC incomes increase, demand for primary goods increases proportionately less.

100

I: Primary goods exporters

Q/t

P (index in constant USD)

Q0 QLR

D0

SLR

LR trend, primary goods

As the increase in supply of primary goods (excluding oil) has been outstripping demand for some 50 years, the long run price trend has been decidedly downwards over the long term.

70

DLR

D1

S0 S1

S2

Demand has also increased at a slower rate than supply since importers – primarily MDCs – have increasingly found ways to substitute many primary goods. Also, increased efficiency in use of raw materials together with recycling has helped lower the rate at which demand increases over time.

Improvements in farming methods, new technology in extracting minerals, new methods of locating mineral sources…etc, have all contributed to a remarkable increase in the supply of primary goods over the past 50 years.

Terms of trade, commodities and LDCs Developing countries are frequently highly dependent on a few commodities (primary goods) for export earnings. In fact, 62 out of 141 developing countries depended on non-oil commodities for over 50% of all export earnings in 2000 – and if oil is included, the number rises to 95.1

(Source: UNDP, “Commodity Dependence and International Commodity Prices” 2010, pages 76 – 79)

SUMMARY OF TERMS OF TRADE AND LDCS In economic shorthand: supply for commodities has been outstripping demand for over 60 years → ∆↓price of commodities ∆↓terms of trade (low PED for exports) ∆↓export revenue ∆↓current account and ↓∆Y.

The results of falling terms of trade for developing countries are almost always negative:

1 UNDP, “Commodity Dependence and International Commodity Prices” 2010, pages 76 – 79

Higher costs of debt servicing as a greater quantity of exports are necessary to earn a given amount of foreign currency with which to repay foreign debt.

Current account deficits often lead to increased borrowing – which in turn increases the debt burden. Falling commodity prices often encourage producers in developing countries to increase production of commodities –

which further depresses the world price of the commodity. Deteriorating terms of trade reduce much-needed imports such as capital, intermediate products in production, and fuel.

All are needed to industrialise and increase value-added output.

However…Australia, one of the largest exporters of commodities in the world, has seen GDP growth of an average 5.3% annually in the latter half of the 2000s – more than half of this growth came from commodity exports. Most of this is due to China’s incredible appetite for raw materials. For example, between 2000 and 2010, Chinese imports (in USD terms) of iron increased by a factor of 42.5 and coal by a factor of 248! 2 Exports of minerals and agricultural goods made up 57% of Australia’s exports in 2012 and exports made up 20% of Australian GDP – which means that 11.45 of export revenue came from primary goods.

The terms of trade : The terms of trade for Australia improved monumentally from 2000 onward – by over 70% just before the economic crises hit in 2008. This was caused by high demand for Australian commodity exports and…

…the exchange rate , which was export-led primarily. As the mining sector expanded to feed China’s voracious appetite for raw materials, FDI poured in as foreign mining syndicates established in Australia. By 2010, 32% of all FDI inflows to Australia were in the mining sector.3 This helps explain the current account deficit – billions were coming in on the financial account!

Current account : So, high growth, massive FDI and a strong exchange rate. This indicates a hefty current account deficit according to economic theory. I checked; Australia has something of a current account record in the OECD; the country has been running a current account deficit since 1972. So, while this makes the deficits during the 2000s somewhat less intimidating, one can still see that rising terms of trade and a strengthened Australian dollar almost consistently worsened the current account during the 2002 to 2008.

PREPARING FOR EXAMSSHORT ANSWER QUESTIONS (10 MARKS EACH)1. “A current account deficit damages the domestic economy.” Discuss.

2. Explain how a country which is experiencing a “boom” in the domestic economy might see the current account go into a deficit.

3. How might a country’s exchange rate influence the balance of payments?

4. How might deteriorating terms of trade improve the current account in the balance of payments?

5. “An appreciation of the exchange rate is always beneficial to an economy”. Discuss.

6. Why might a devaluation of a country’s currency not necessarily improve the current account in the short run?

EXTENDED RESPONSE QUESTIONS (25 MARKS EACH) 1. (a) What problems might arise for a country running a current account deficit? (10 marks)

(b) How might the deficit be reduced? (15 marks)

2 http://www.reuters.com/article/2011/11/30/us-australia-china-idUSTRE7AT2HY20111130 and http://www.theaustralian.com.au/business/mining-energy/china-forecast-suggests-commodities-boom-has-peaked/story-e6frg9df-1226291178832

3 http://www.business.nsw.gov.au/invest-in-nsw/about-nsw/trade-and-investment/foreign-direct-investment-in-australia-by-industry

2. (a) Distinguish between the “terms of trade” and the “balance of trade”. (10 marks) (b) How might both be affected by a fall in the country’s exchange rate? (15 marks)

3. (a) Explain how a country might have a consistent current account deficit for longer periods. (10 marks) (b) Is this necessarily a serious problem? (15 marks)

Taken out of Ch 69. 4. a) Account for the difficulties of establishing a common currency amongst 10 countries. (10 marks)

b) Discuss the costs and benefits of establishing a common currency. (15 marks)

Summary and revision Improved terms of trade have positive re-distribution effects: Living standards improve as consumers can consumer more imports and have more choice External debt decreases in terms of export revenue Firms can import cheaper factors of production in terms of exports Better terms of trade can improve current account if exports and/or imports are price inelastic

Improved terms of trade can also come with disadvantages: Current account might worsen since exports are dearer and imports are cheaper

A deterioration of the terms of trade has possible benefits: As relative export prices have fallen, there might be an improvement in current account Increased exports might increase aggregate demand and thus income

Possible disadvantages of deterioration of the terms of trade: Higher import prices impact on consumers in terms of choice and living standards Export-driven economies might see the external debt burden increase For export goods that are price inelastic, a deterioration of the terms of trade might lead to a worsening of current account

Low PED, PES and yED for primary goods has disadvantaged primary goods exporting LDCs: Low PED and PED has led to extreme price volatility over many yearsLow yED for primary goods has often meant that demand from MDCs for primary goods has not increased in tune with growth Supply outstripping demand has lowered commodity prices in real terms over almost 50 years

Falling commodity prices has led to a deterioration of the terms of trade for developing nations over most of the past 50 years. Effects of this include: Current account deficits as export revenues fall Increased debt burdens since much of the debt is accrued from the foreign sector and export revenues are needed to service the debt Imports of much-needed capital goods become dearer in terms of export revenues