Terms of trade

Given the following prices of import and export, calculate the terms of trade:

Calculate price index:

Soln:

$\text{Price Index (1990, Export)} = \frac{P_n}{P_o} \times 100 = \frac{100}{100} \times 100 = 100\%$

$\text{Price Index (1991, Export)} = \frac{594}{540} \times 100 = 110\%$ (doube check: 594 ÷ 540 = 1.1)

$\text{Price Index (1991, Import)} = \frac{6480}{4500} \times 100 = 144\%$

$\text{Price Index (1992, Export)} = \frac{621}{540} \times 100 = 115\%$

$\text{Price Index (1992, Import)} = \frac{4860}{4500} \times 100 = 108\%$

$\text{Price Index (1993, Export)} = \frac{648}{540} \times 100 = 120\%$

$\text{Price Index (1993, Import)} = \frac{5400}{4500} \times 100 = 120\%$

Total price index:

1. Net barter / commodity terms of trade Is the ratio of price index of exports and price index of imports.

   $\text{T.O.T Net barter} = \frac{P_X}{P_M} \times 100$

2. Income term of trade / capacity to import It is the ratio between the product price index for export and quantity of export to the price index of imports.

   $\text{Income T.O.T} = \frac{P_X Q_X}{P_M} \times 100$

   Where:

   • $Q_X = \frac{V_X}{P_X}$ (Volume of export)
   • $V_X$ = Volume of export and $P_X$ = Price index of export

3. Gross barter

   $\text{T.O.T} = \frac{Q_X}{Q_M} \times 200$

   Where:

   • $Q_X$ = Quantity of export
   • $Q_M$ = Quantity of import

Favourable terms of trade

It occurs when a country export prices rises while the import prices decline or remain constant. This implies that a country can get more import by exporting the same quantity of export.

Unfavourable terms of trade

Countries terms of trade are said to be unfavourable when the price of export declines or remain constant while the price of import rises. This implies that there is less foreign exchange coming from export.

Balance terms of trade

Balance terms of trade occurs when terms of trade between two countries is equal to one.

These are the factors which determine whether terms of trade are favourable, unfavourable or balance.

1. Forces of demand and supply When the demand of export raises the price of export increases leading to favourable T.O.T and Vice versa.

2. The degree of monopolization When there is a monopoly, high degree of monopoly power terms of trade are favourable.

3. Import Quota This means quantitative restriction. It leads to unfavourable terms of trade to the exporting countries.

4. Devaluation This is lowering of country currency which lead export to be cheaper and import expensive hence unfavourable.

5. Tariffs (import duty) Increase in import duty leads to increases in import prices, leading to unfavourable terms of trade.

1. Increase in supply of exports which leads to decrease in their prices When a country produces and exports more goods, the increased supply can push down the prices, leading to unfavorable terms of trade, as the country receives less income for its exports.

2. Decrease in demand for a country's export leading to fall in export price A decline in the global demand for a country's exports will reduce the price that buyers are willing to pay, negatively affecting the terms of trade.

3. An increase in demand for imports leading to an increase in their price If the demand for imports rises, their prices increase, worsening the terms of trade as the country has to pay more for the same amount of imports.

4. Political instability affecting production Political instability, such as war or government instability, can disrupt production, reduce the supply of exports, and lead to a decline in export prices, worsening the terms of trade.

1. Decrease in supply of exports which leads to increase in their prices If the supply of a country's exports falls due to factors such as reduced production or scarcity, the price of exports may rise, improving the terms of trade.

2. Increase in demand for a country's export leading to rise in export price When demand for a country's exports increases, the price for those exports tends to rise, positively influencing the terms of trade.

3. A decrease in demand for imports leading to a decrease in their prices If the demand for imports drops, the price of imported goods falls, benefiting the country by reducing its import costs, thus improving the terms of trade.

Qn: Discuss why terms of trade in LDCs are mostly unfavourable:

1. Discovery of synthetic materials in developed countries (e.g., nylon and plastic bags) The invention of synthetic materials by developed countries has reduced their reliance on raw materials from less developed countries (LDCs). This decreases demand for primary goods exported by LDCs, leading to lower prices and unfavorable terms of trade.

2. Introduction of import substitution industry in developed countries Developed countries have built industries that produce goods which were originally imported. This reduces their need for imports from LDCs, thus decreasing demand for LDC exports and making their terms of trade unfavorable.

3. Diminishing returns LDCs are largely agricultural, and the land available for production is limited. As population grows, the yield from existing land diminishes (diminishing returns), and the supply of agricultural goods increases, leading to lower prices. Many of the products from LDCs have low price elasticity, while manufactured products have higher elasticity, resulting in unfavorable terms of trade.

4. Introduction of raw material-saving technology in developed countries (e.g., recycling) Technological advancements, such as recycling and the use of alternative materials, reduce the demand for raw materials from LDCs. This lowers the value of exports from LDCs and worsens their terms of trade.

5. Monopoly power of primary products (e.g., petroleum) Developed countries control the production of many key primary products like petroleum, which gives them monopoly power over prices. LDCs, which depend on the export of primary products, face unfavorable terms of trade when prices of these products are controlled by a few countries.

6. Technology level in LDCs LDCs tend to have lower levels of technological development compared to developed countries. This limits their ability to produce high-value manufactured goods, and they remain reliant on exporting low-value primary products, resulting in unfavorable terms of trade.

Qn: Discuss the possible solution for deteriorating terms of trade in LDCs:

The following are some of the solution:

1. Controlling imports by reducing imports, using import substitution method, recycling By reducing imports and encouraging the production of goods domestically (import substitution), LDCs can reduce reliance on foreign products. Recycling helps maximize the use of domestic materials, reducing the need for imports and improving trade balances.

2. Using economic integration where countries come together and remove barriers (including tariffs) Economic integration, such as regional trade agreements, can create a larger market for LDCs' exports. By removing trade barriers, such as tariffs, LDCs can increase their exports and potentially secure better terms of trade.

3. Use of export promotion Encouraging the production and export of goods through incentives can increase demand for a country's exports. Increased demand can drive up the price of exports, improving the terms of trade for LDCs.

4. Improvement in technology (using modernized machines) LDCs can adopt advanced technologies to increase the efficiency and quality of their production. This would allow them to produce more competitive goods, especially manufactured products, which are more elastic in price and can improve terms of trade.

5. Control population A growing population leads to increased demand for goods and services. By controlling population growth, LDCs can better manage the demand for resources, reduce pressure on local industries, and potentially stabilize terms of trade.

6. Investment in manufacturing industry that produces goods with high elasticity Investing in industries that produce goods with higher price elasticity, such as manufactured products, can help LDCs diversify their exports. This reduces reliance on primary goods and improves terms of trade by focusing on higher-value-added products.

7. Discovery of new resources Finding new natural resources or untapped markets can provide LDCs with a broader base for exports. By diversifying their resource base, they can reduce vulnerability to fluctuations in the prices of primary commodities and improve their terms of trade.

Is the difference between the value of the countries visible export and visible imports:

• Visible trade involves buying and selling physical goods.
• Invisible trade involves buying and selling services.

Balance of trade can either be favourable or unfavourable:

• Favourable balance of trade occurs when the value of export exceed the value of import.
• Unfavourable balance of trade occur when import value exceed export value.

$\text{B.O.T} = \text{Total value of exports} - \text{Total value of imports}$

Is an accounting statement that shows the difference between inflow (receipts) and outflow (payment) of foreign currency within a specific time.

Balance of payment is divided into the following account:

a. Current Account

This account records day-to-day transactions between a country and the rest of the world. It includes:

1. Goods and Services Account It records trade in tangible goods (visible trade) and intangible services (invisible trade) between countries.

2. Unilateral Transfers These are one-way transactions where the country either gives or receives grants, gifts, and aid, without a direct exchange (e.g., foreign aid or remittances).

The Current Account shows:

1. Difference between visible exports and visible imports This is the balance of trade in goods — export of physical products vs. import of physical products.

2. Difference between invisible exports and invisible imports This covers the trade in services — such as tourism, insurance, and banking services.

Formula

$\text{Net Current Balance} = (\text{Visible Exports} - \text{Visible Imports}) + (\text{Invisible Exports} - \text{Invisible Imports})$

Net Current Balance

• Surplus: More income is received from exports than paid for imports.
• Deficit: More money is spent on imports than earned from exports.

b. Capital Account

This account records capital movements between a country and the rest of the world, including both private and government investments.

1. Net Long-Term Capital Inflow This includes investments like foreign direct investment (FDI), loans, and bonds that last more than one year.

2. Net Short-Term Capital Inflow Refers to portfolio investments and financial instruments that are short-term in nature, such as treasury bills.

3. Net Short-Term Government Capital Inflow This includes government borrowing or lending for short-term purposes.

4. Net Long-Term Government Capital Inflow This refers to long-term borrowing or investment by the government (e.g., international development loans).

Capital Account Balance

• Surplus: Total capital inflows exceed capital outflows (more money coming into the country).
• Deficit: Total capital outflows exceed inflows (more money leaving the country).

c. Financial Account

This account records international monetary flows such as investment in business, real estates and in stock exchange.

Occurs when total payments to abroad exceed total receipts from abroad.

The following are its major causes:

1. Increase in demand for imports When a country imports more goods, it spends more foreign currency, leading to a trade deficit as outflows exceed inflows.

2. Decrease in demand for export products If global demand for a country's exports falls, export earnings drop, worsening the trade balance.

3. Devaluation policy Devaluation can make imports cheaper and exports more expensive, reducing competitiveness and increasing import expenditure.

4. Unfavourable terms of trade When a country exports low-priced goods and imports high-priced ones, it pays more than it earns, creating an imbalance.

5. Poor climatic conditions (especially in agricultural-based countries) Bad weather affects crop output, reducing exports and increasing food imports to cover shortages.

6. Trade sanctions Restrictions or bans on trade by other countries can limit a country's exports, leading to reduced foreign income.

7. Inadequate capital goods leading to low production Without machinery and infrastructure, countries can't produce enough for export, limiting their trade potential.

1. Reducing importation through trade restrictions Implementing tariffs, quotas, or bans helps lower import levels and protect local industries.

2. Promote export Supporting local producers to increase the quantity and quality of exports improves earnings from foreign markets.

3. Devaluation of currency combined with import restriction Lowering the value of local currency makes exports cheaper and imports more expensive, encouraging local consumption and boosting foreign sales.

4. Proper utilization of resources Efficient use of natural, human, and capital resources can increase domestic production for both local use and export.

5. Seek for more financial assistance Getting grants, loans, or aid from international institutions can temporarily stabilize the trade balance and fund export-promotion efforts.

6. Restrict or reduce capital outflow Controlling the movement of funds abroad preserves foreign exchange reserves and supports domestic investment.