Measurement: The price of the exported good over the price of the imported good. The easiest way to measure the terms of trade, for a country, is by indexing the values (because there are thousands of goods being traded).
The average price of exports is divided by the average price of imports at a given point in time. For ease of use, the average prices are commonly indexed.
TERMS OF TRADE INDEX: the average price of exports over the average price of imports. A decrease in the terms of trade index shows a deterioration of the terms of trade.
(Index of the average price of exports / index of the average price of imports) x 100
The base year value of the terms of trade index is 100; both the average price of exports and imports is indexed at 100.
Over time, if the terms of trade drops (that is, the price of exports increases to the price of imports) the terms of trade is improved. If the opposite, the terms of trade has deteriorated.
Ex. Terms of Trade increases from 100 to 105 = improvement.
Ex. Terms of Trade decreases from 105 to 100 = deterioration.
Causes:
Short Run
Exchange rate: depreciation of home currency worsens terms of trade; 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 supply of export goods will lower the terms of trade -- especially goods which are demand inelastic.
Trade barriers, intervention purchasing/selling of the home currency and devaluation: a country can intentionally alter the terms of trade.
A booming economy: can attract investment funds and causing 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
Increased investments and supply-side policies: increases 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.
Increasing incomes: will shift demand towards secondary and tertiary goods with higher income elasticities; increase the terms of trade for industrialized countries; and, decrease the terms of trade for countries dependent on exports of primary goods.
International Commodity Agreements: can use buffer stocks and pricing agreements to keep prices at a desired level.
Purchasing Power Parity Theory: 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.
Marshall-Lerner Condition: For a devaluation to be considered successful, certain conditions of price elasticities must be upheld. It is possible for the current account to improve even when either exports or imports are demand inelastic. The Marshall-Lerner Condition summaries this, in stating that devaluation will improve the current account, as long as the sum of the price elasticity of demand for exports plus the price elasticity of demand for imports is greater than one. Conversely, if the sum of price elasticities of demand for exports and imports is less than one, a revaluation of the currency will improve the current account.
Definition: If the sum of the price elasticities of demand for exports and imports is greater than one, a devaluation will improve current account in the balance of payments.
Devaluation: PEDx + PEDm > 1 = Current Account Improves
Revaluation: PEDx + PEDm < 1 = Current Account Improves
J-Curve: The conclusion that a devaluation leads to an increase in net export revenue is generally valid. However, depending on how quickly households, importers and exporters respond to the effective change in relative prices, there might initially be a worsening in the current account.
REASONS:
1. The Marshall-Lerner condition may not be upheld as the price elasticities for exports and imports are likely to be relatively inelastic in the short run. It will take time for firms importing raw materials and components to find alternative sources, so a devaluation will in fact worsen the balance of payments, as firms in the short run continue to purchase imported factors of production at higher import prices.
2. Firms are locked into contracts (sticky) for months in advance. An importer with a contract in foreign currency to be paid six months down the road will have to pay more to fulfill the contract after a devaluation. Similarly, exporters contracted in foreign currency will receive less in home currency. Both cases will cause the current account to worsen.
3. It takes time for both firms and consumers to adjust to the fact that relative prices have changed and thereby change expenditure habits.
ON GRAPH:
T0: Devaluation of Currency
T0-T1:A current account deficit is countered by a devaluationat T0, whereupon there is an initial worsening up to point T1, as household and firms have difficulties in adjusting to the new exchange rate, in the short run.
Contracts
Time
Regulations
T1: Initial Worsening of the Current Account
T1-T2: Ultimately, domestic firms will find alternative (lower cost) sources of factor inputs and long run commitments (contracts) will end; households will alter spending habits more in favor of domestic goods; and foreign trade partners will increase their purchase of goods and services of the country, which has devaluated. Taken together, import expenditure is falling and export revenue is rising, so the current account starts to improve.
T2: The current accounts is back to pre-devaluation level.
Beyond T2: Beyond T2, the balance of payments shows a smaller current account deficit than pre-devaluation and at T3, the balance of payments is in perfect equilibrium. Beyond T3, the current account moves into surplus.
Measurement: The price of the exported good over the price of the imported good. The easiest way to measure the terms of trade, for a country, is by indexing the values (because there are thousands of goods being traded).
Causes:
Short Run
Long Run
Marshall-Lerner Condition: For a devaluation to be considered successful, certain conditions of price elasticities must be upheld. It is possible for the current account to improve even when either exports or imports are demand inelastic. The Marshall-Lerner Condition summaries this, in stating that devaluation will improve the current account, as long as the sum of the price elasticity of demand for exports plus the price elasticity of demand for imports is greater than one. Conversely, if the sum of price elasticities of demand for exports and imports is less than one, a revaluation of the currency will improve the current account.
Definition: If the sum of the price elasticities of demand for exports and imports is greater than one, a devaluation will improve current account in the balance of payments.
J-Curve: The conclusion that a devaluation leads to an increase in net export revenue is generally valid. However, depending on how quickly households, importers and exporters respond to the effective change in relative prices, there might initially be a worsening in the current account.
REASONS:
ON GRAPH: