Terms of trade (TOT)
Syllabus: Explain the meaning of the terms of trade.
Before you start note
that IB students every year have difficulties with this concept and so
it is probably the most asked about topic in International Economcs by
the IB. If you understand the basic concept however you should have no
difficulty.
| Definition: The terms of trade is the amount of imports that can be exchanged for one unit of exports |
Can you recall the
Theory of Comparative Advantage? When explaining this theory it was
necessary to choose the terms of trade so that levels of trade could be
established as in:
The terms of trade measures
the purchasing power of a country's exports, e.g. how many units of
exports are needed to buy a unit of imports. As each country is
exporting and importing many different products, the Terms of Trade are
calculated using the export price index (shows combined price changes
of all exported products) and import price index (shows the combined
changes in prices of all imported goods).
Formula to calculate the ToT
In the Latest Paper 3 the markscheme said the equation MUST have either average or index or else it was not acceptable.
Syllabus: Explain how the terms of trade are measured.
While
the ToT are defined in terms of units of goods and services it is
impossible to add up the enormous variety of Exports and Imports and
come to a meaningful quantity. One of the functions of money is as a
measure of value and so the ToT are calculated by value, hence the use
of Index of Prices.
Syllabus: Distinguish between an improvement and a deterioration in the terms of trade.
An improvement in the terms of trade must mean that one of the following changes has taken place:
- Export prices have risen, import prices have stayed the same
- Export prices have risen, import prices have fallen
- Export prices have risen faster than import prices
- Export prices have fallen by less than import prices
- Export prices have stayed the same but import prices have fallen
A increase in the terms of trade
ratio is generally described as an improvement, or favourable movement,
in the terms of trade. This is because the same volume of exports will
now buy more imports.
A decrease in the terms of trade
ratio is generally described as a deterioration, or a worsening or
unfavourable movement, in the terms of trade. This is because the
country can afford fewer imports with the same volume of exports.
NB.
An improvement in the Terms of Trade does not necessarily mean it has a
positive effect on the economy and vice versa. Can you say why?
