Impact of terms of trade on the economy
Prices of commodities are more volatile than for manufactured goods. Many developing countries are vulnerable to deterioration in the terms of trade, because they are very dependent on exports of primary commodities - minerals, agricultural commodities like coffee etc. If prices of these commodities on world markets fall, then they face a deterioration in their terms of trade. They are earning less from the same volume of exports and this means that they cannot afford to import as much. Their standard of living has fallen, not because of anything they did, but simply due to the vagaries of world markets.
The impact of changes in the terms of trade on the standard of living:
- An improvement in the terms of trade may improve the standard of living in a country - the same volume of exports will buy more imports.
- A deterioration in the terms of trade may reduce the standard of living as more exports have to be sold to pay for the same volume of imports.