Skip to main content

Impact of terms of trade on the balance of payments

S:\triplea_resources\DP_topic_packs\economics\student_topic_packs\media_macroeconomics\images\gears_accelerator.jpgAn improvement in terms of trade does not necessarily mean an improvement in the balance of payments.

If the terms of trade improve, this means that export prices have increased more than import prices. This may, however, indicate a deterioration in competitiveness and in the medium-term may lead to a fall in export demand. How much export demand falls will depend on the price elasticity of demand for exports. This may adversely affect the balance of payments.

Similarly, a deterioration in the terms of trade may actually indicate an improvement in competitiveness. This is because import prices have risen more than export prices, possibly showing that exports are more competitive. In the medium-term demand for exports may rise and lead to an improvement in the current account.

The effect of changes in the terms of trade on the balance of payments will depend on the price elasticities of demand for imports and exports.