Terms of Trade: Economic Impact and Policy Responses

Understanding Terms of Trade (TOT)

TOT Definition and Calculation

The Terms of Trade (TOT) is an economic indicator that measures the relative prices of a country's exports in relation to its imports. It quantifies the amount of imports a country can obtain per unit of its exports.

The formula for calculating TOT is:

TOT = (Average Price Index of Exports / Average Price Index of Imports) x 100

Interpreting Changes in Terms of Trade

Changes in the TOT indicate shifts in a country's purchasing power in international trade:

• TOT Improves / More Favorable: This occurs when export prices rise relatively to import prices. The country is then able to exchange the same amount of exports for a greater quantity of imports. This generally signifies an increase in national income and purchasing power.
• TOT Worsens / Less Favorable: This happens when export prices decrease relatively to import prices. Consequently, the country must use a larger quantity of exports to obtain the same amount of imports. This typically indicates a decrease in national income and purchasing power.

Factors Influencing Terms of Trade

Key Determinants of Export (PX) and Import (PM) Prices

Several factors can cause fluctuations in a country's Terms of Trade:

• Increased Demand for Exports: A rise in global demand for a country's exports leads to an increase in export prices (PX), resulting in a more favorable TOT.
• Improvement in Export Quality: Enhanced quality of exported goods can command higher prices (PX), thereby improving the TOT.
• Exchange Rate Depreciation: When a country's currency depreciates, import prices (PM) typically increase in local currency terms, which can lead to a worsening of the TOT.
• Productivity Improvement: Increased productivity can lower the cost of production, which may lead to a decrease in export prices (PX) to maintain competitiveness. This can result in a less favorable TOT.
• Higher Domestic Inflation: If domestic inflation causes export prices to rise faster than import prices, the TOT can become more favorable. However, this can also lead to a loss of competitiveness if not managed carefully.

Consequences of Terms of Trade Fluctuations

Short-Run Impacts of TOT Deterioration

When the Terms of Trade deteriorate (export prices become relatively cheaper):

• Increased Export Competitiveness: Cheaper exports can lead to an increase in demand for them, potentially boosting export revenue.
• Reduced Import Expenditure: Imports become relatively more expensive, which might reduce import expenditure.
• Current Account Balance: A less favorable TOT can improve the current account balance if the Marshall-Lerner condition is satisfied (Price Elasticity of Demand for Exports + Price Elasticity of Demand for Imports > 1). In this scenario, the increase in export volume and decrease in import volume outweigh the price changes.
• Initial Impact: However, in the very short term, before demand fully adjusts, a deterioration in TOT might initially worsen the current account balance as the value of exports falls relative to imports.

Evaluation: The actual short-run impact on the current account balance heavily depends on whether the Marshall-Lerner condition is satisfied.

Long-Run Impacts of TOT Deterioration

Over the long term, a sustained deterioration in TOT implies that a country must continuously use more and more exports to acquire the same quantity of imports. This can lead to:

• Global Income Redistribution: A long-term shift of income from countries experiencing TOT deterioration to those with improving TOT.
• Economic Implications: The significance of this redistribution depends on the underlying causes of the TOT deterioration:
  • Due to Higher Productivity and Lower Production Costs: This might be a positive sign, indicating increased price competitiveness and efficiency, even if it means lower export prices.
  • Due to Lower Quality or Decreased Demand: This represents a more significant problem, signaling lower quality competitiveness or a decline in demand for the country's products.

Important Note: An improvement in TOT caused by inflation, particularly if demand for exports is relatively elastic, can lead to a depreciation in the current account balance as higher prices reduce export volumes significantly.

In summary, TOT deterioration means a greater quantity of exports is required in exchange for the same unit of import.

Currency Management: Preventing Appreciation

Governments and central banks may implement policies to prevent excessive currency appreciation, which can negatively impact export competitiveness. Strategies include:

1. Interest Rate Adjustments: Decreasing domestic interest rates can encourage capital outflow, as investors seek higher returns in other currencies. This increases the supply of the domestic currency (e.g., AUD) in the foreign exchange market, thereby counteracting appreciation pressure.
2. Foreign Exchange Market Intervention: The government or central bank can directly intervene by selling its domestic currency (e.g., AUD) and buying foreign currency in the foreign exchange market. This action increases the supply of the domestic currency, helping to prevent its appreciation.