May, 2006, Paper 1, #3a “Explain why an improvement in a country’s terms of trade does not always lead to an improvement in its balance of payments on current account” & #3b “An economy is currently experiencing a deficit on the current account of its balance of payments. The government is considering either allowing the exchange rate to fall or reducing aggregate demand”

Demands of the question:

The question should be tackled so that there are 25 minutes allocated for part “a” while the remaining 35 minutes should be allocated for part “b”. In order to score well in these questions, appropriate diagrams should be included for part “a” and “b”. Make sure to explain how improvements in a country’s terms of trade do not always lead to an improvement in a countries balance of payments on current account. Also, give pros and cons of allowing exchange rates to fall or reducing aggregate demand.

Definitions:

Terms of Trade – the rate at which one country’s goods exchange against another.

Balance of payments – the value of all the transactions between the residents of a country with the residents of all other countries over a given time period.

Deficit – Revenue from export of goods and services and income flows is less than the expenditure on the import of goods and services and income flows over a given time period.

Exchange rate – value of one currency expressed in terms of another.

Aggregate demand – total spending in an economy by consumers.

Triple A Notes:

“To simplify the terms of trade, let’s say that we export one good and import just one. Obviously not an exciting situation, but it helps us see how we measure the terms of trade. To make it more interesting, let’s say we export beer and import wine. If 2 units of beer exchange for 1 unit of wine (an exchange ratio or rate of 2/1), then the price of beer will be half that of wine. In other words we can buy 1 unit of wine for every 2 of beer that we export. The terms of trade is therefore 1/2 and we measure it from the formula: price of beer/price of wine (export price/import price). So, the terms of trade is the rate at which one country’s goods exchange against another.

In the real world we export and import a lot more than just wine and beer and goods are rarely exchanged in physical units. International trade is usually carried out through the use of prices. In practice, therefore, the terms of trade is expressed as the price relationship between a country’s imports and exports.

This is usually expressed as an index. This means that any price changes are measured as a percentage change against a base year.”

Consequences of a change in terms of trade – balance of payments and economy

Changes in the terms of trade will have a significant impact on an economy. For example, many developing countries are very dependent on exports of primary commodities – minerals, agricultural commodities like coffee etc. If prices of these commodities on world markets fall (as has been the case in recent years) 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.

This shows us the main impact of changes in the terms of trade – the effect 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.

However, we also need to take account of the impact on competitiveness of these price changes. If the terms of trade has improved, then this means that export prices have increased more than import prices. This may 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.

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

So, analysing the terms of trade is not a simple matter. Prices of imports and exports will constantly be changing according to supply and demand and the average changes in these prices will show up in the terms of trade. An improvement in the terms of trade may well be good news for exporters, but are they perhaps less competitive in the medium term as a result? For developing countries that are very dependent on a narrow range of primary exports, the terms of trade will be crucial to their ability to grow and to fund essential imports.”

Elasticity of demand for imports and exports

A favourable movement in the terms of trade may have an unfavourable effect on the trade balance, while an unfavourable movement in the terms of trade may favourably affect the trade balance. This is because the terms of trade records relative price movements of exports and imports, while the current account of the balance of payments is concerned with export and import values (price x quantity bought / sold).

The impact of a change in the terms of trade on the trade balance will largely depend on the price elasticity of demand for exports and imports.

An improvement (favourable movement) in the terms of trade may worsen the trade balance – this will occur when the demand for exports and imports is price elastic.

An improvement in the terms of trade means that the price of exportsincreases relative to the price of imports.”

The overall impact on the balance of payments of a change in the terms of trade depends on the combined price elasticities of demand for imports and exports. So:

• An improvement in the terms of trade will worsen the balance of payments if the demand for exports and imports is price elastic, andimprove it if demand for exports and imports is price inelastic.
• A deterioration in the terms of trade will worsen the balance of payments if the demand for exports and imports is price inelastic andimprove it if demand is price elastic.

Given that the developing countries’ demand for exports and imports is relatively price inelastic, they have faced ever worsening balance of payments situations in response to their deteriorating terms of trade.”

Diagrams:

- Diagrams that show elastic and inelastic demand

- Diagrams that show an increase in supply for a currency

- Diagrams that show decrease in aggregate demand

Evaluation suggestions:

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