Key unit competence: Learners will be able to describe the terms of

My goals

By the end of this unit, I will be able to:

⦿ Differentiate between income and barter terms of trade.

⦿ Describe the nature of terms of trade in LDCs.

⦿ Identify factors for improving terms of trade in LDCs.

⦿ Demonstrate the terms of trade and balance of trade in LDCs through
calculations and make interpretation.

⦿ Analyse the ways of improving terms of trade in LDCs.

⦿ Assess the causes and consequences of changes in terms of trade.

⦿ Take part in improving terms of trade in LDCs/Rwanda.

2.1 Meaning of Terms of Trade

Activity 1

Using the case study below, visit the library, the internet or any other economics source and research about terms of trade. Using the gained knowledge, share and discuss as a class the questions that follow.

In 2015, Rwanda exported her coffee to Japan and in turn imported cars from there. The price of coffee per ton was 800 dollars while that of a car was 1,700 dollars. The following year i.e. 2016, coffee prices in the world market fell by 20% while that of cars remained constant.

(a) What economic term do we call the relationship between  Rwanda’s export prices and import prices?

(b) Calculate the terms of trade for Rwanda in 2015 and 2016 respectively.

(c) Describe the nature of terms of trade of Rwanda in 2015  and 2016 respectively. Support your answer.

(d) How can terms of trade be expressed?

Facts

Terms of trade (TOT) refers to the relative price of exports in terms of imports. It is the ratio of export prices to import prices. It can be interpreted as the amount of import goods an economy can purchase per unit of export goods, i.e. import purchasing power of exports. For example, if an economy
is only exporting coffee and only importing cars, then the terms of trade are simply the price of coffee over the price of cars. In other words, how many cars can you get for a unit of coffee? Since economies typically export and import many goods, measuring the terms of trade requires defining price
indices for exported and imported goods and comparing the two.

A rise in the prices of exported goods in international markets would increase the terms of trade, while a rise in the prices of imported goods would decrease the terms of trade. For example, countries that export oil

will see an increase in their terms of trade when oil prices go up, while the terms of trade of countries that import oil would decrease.

An improvement of a nation’s terms of trade benefits that country in the sense that it can buy more imports for any given level of exports. The terms of trade may be influenced by the exchange rate because a rise in the value of a country’s currency lowers the domestic prices of its imports but may
not directly affect the prices of the commodities it exports.

Terms of trade is the ratio of a country’s export price index to its import price index, multiplied by 100. The terms of trade measure the rate of exchange of one good or service for another when two countries trade with each other.

Basically, TOT is Export Price over Import Price times 100. If the percentage is over 100% then an economy is doing well (Capital Accumulation) thus favourable terms of trade. When this persists year after year, a country is said to have improving terms of trade.

If the percentage is under 100% then an economy is not doing well (more money going out than coming in) thus unfavourable terms of trade. When this persists year after year, a country is said to have deteriorating terms of trade.

2.2 Forms of Terms of Trade

Terms of trade are categorised into two, namely;

Barter / commodity terms of trade is the relationship between export prices and import prices, i.e. the ratio of average price index of exports to the average price index of imports. Symbolically, it can be expressed as:

Taking 2012 as the base year and expressing Rwanda’s both export prices and import prices as 100, if we find that by the end of 2015 its index of export prices had fallen to 80 and the index of import prices had risen to

It implies that Rwanda’s terms of trade declined by about 33.33 per cent in
2015 as compared to 2012, thereby showing worsening of its terms of trade.

If the index of export prices had risen to 150 and that of import prices to 130, then the terms of trade would be;

This implies an improvement in the terms of trade by 15.2 per cent in 2015
over 2012.

Limitations of barter terms of trade

Despite its use as a device for measuring the direction of movement of the gains from trade, this concept has important limitations.

1. Problems of index numbers

Usual problems associated with index numbers in terms of coverage, base
year and method of calculation arise.

2. Change in quality of product

The commodity terms of trade are based on the index numbers of export and import prices. But they do not take into account the changes taking place in the quality and composition of goods entering into trade between two countries. At best, commodity terms of trade index show changes in the relative prices of goods exported and imported in the base year. Thus

the net barter terms of trade fail to account for big changes in the quality of goods that are taking place in the world, as also new goods that are constantly entering in international trade.

3. Problem of selection of period

The problem arises in selecting the period over which the terms of trade are studied and compared. If the period is too short, no meaningful change may be found between the base date and the present. On the other hand, if the period is too long, the structure of the country’s trade might have changed
and the export and import commodity content may not be comparable between the two dates.

4. Cases of changes in prices

Another serious difficulty in the commodity terms of trade is that it simply shows changes in export and import prices and not how such prices change. As a matter of fact, there is much qualitative difference when a change in the commodity terms of trade index is caused by a change in export prices
relative to import prices as a result of changes in demand for exports abroad, and ways or productivity at home. For instance, the commodity terms of  trade index may change by a rise in export prices relative to import prices due to strong demand for exports abroad and wage inflation at home. The
commodity terms of trade index do not take into account the effects of such factors.

5. Neglect of import capacity

The concept of the commodity terms of trade throws no light on the country’s “capacity to import”. Suppose there is a fall in the commodity terms of trade in Rwanda, it means that a given quantity of Rwandan exports will buy a smaller quantity of imports than before. Along with this trend, the volume of Rwandan exports also rises may be as a consequence of the fall in the prices of exports. Operating simultaneously, these two trends may keep Rwanda’s capacity to import unchanged or even
improved. Thus the commodity terms of trade fails to take into account a country’s capacity to import.

6. Ignores productive capacity

The commodity terms of trade also ignore a change in the productive
efficiency of a country. Suppose the productive efficiency of a country

increases, it will lead to a fall in the cost of production and in the prices of its export goods.
The fall in the prices of export goods will be reflected in the worsening of its commodity terms of trade. But, in reality, the country will not be worse off than before. Even though a given value of exports will exchange for less imports, the country will be better off. This is because a given volume
of exports can now be produced with lesser resources, and the real cost of imports, in terms of resources used in exports, remains unchanged.

7. Not helpful in Balance of Payment disequilibrium

The concept of commodity terms of trade is valid if the balance of payments of a country includes only the export and imports of goods and services, and the balance of payments balances in the base and the given years. If the balance of payments also includes unilateral payments or unrequired exports
and or/imports, such as gifts, remittances from and to the other country, etc., leading to disequilibrium in the balance of payments, the commodity terms of trade is not helpful in measuring the gains from trade.

The concept of commodity terms of trade fails to explain the distribution of gains from trade between a developed and under-developed country. If the export price index of an underdeveloped country rises more than its import price index, it means an improvement in its terms of trade. But if there is an equivalent rise in profits of foreign investments, there may not be any gain from trade.

This refers to the ratio of the value of exports (revenue from exports) to the price index of imports. This index is calculated by dividing the index of the value of exports by an index of the price of imports. This is called the

A rise in the index of income terms of trade implies that a country can import more goods in exchange for its exports. A country’s income terms of trade may improve but its commodity terms of trade may
deteriorate. Taking the import prices to be constant, if export prices fall, there will be an increase in the sales and value of exports. Thus while the income terms of trade might have improved, the commodity
terms of trade might have deteriorated.

The income terms of trade is called the capacity to import.In the longrun,
the total value of exports of a country must be equal to its total value of imports. Thus determine which is the total volume that a country can import. The capacity of a country to import may increase, other things
remaining the same if;

(i) the price of exports rises,

(ii) the price of imports falls,

(iii) the volume of its exports rises.

Thus the concept of the income terms of trade is of much practical value for developing countries having low capacity to import.

Criticisms of income terms of trade

The concept of income terms of trade has been criticised on the following counts:

1. Fails to measure gain or loss from trade

The index of income terms of trade fails to measure precisely the gain or loss from international trade. When the country’s capacity to import increases, it simply means that it is also exporting more than before. In fact, exports include the real resources of a country which can be used domestically to
improve the standards of living of its people.

2. Not related to total capacity to import

The income terms of trade index is related to the export based capacity to import and not to the country’s total capacity to import which also includes its foreign exchange receipts. For example, if the income terms of trade index of a country have deteriorated but its foreign exchange receipts have risen, its capacity to import has actually increased, even though the index shows deterioration.

3. Inferior to commodity terms of trade

Since the index of income terms of trade is based on commodity terms of trade and leads to contradictory results, the concept of the commodity terms of trade is usually used in preference to the income terms of trade concept for measuring the gain from international trade.

2.2.1 Limitations of terms of trade

• Terms of trade should not be used synonymously with social welfare,   or even Pareto economic welfare. Terms of trade calculations do  not tell us about the volume of the countries’ exports, only relative
changes between countries. To understand how a country’s social   utility changes, it is necessary to consider changes in the volume of   trade, changes in productivity and resource allocation, and changes
in capital flows.

• The price of exports from a country can be largely influenced by the  value of its currency, which can in turn be largely influenced by the  interest rate in that country.   If the value of currency of a particular country is increased due to an  increase in interest rate, one can expect the terms of trade to improve.

However, this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result,
exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price.

• In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.

2.3 Nature of Terms of Trade for LDCs

Activity 2

Imagine a situation in a country where export prices are persistently lower than her import prices year after year, share your views with the rest of the class explaining:

(a) The likely causes of such an incident in Rwanda.

(b) What you think could be done to improve the terms of trade in Rwanda.

Facts

Most LDCs have unfavourable and deteriorating terms of trade. The following are the main reasons for unfavorable and declining terms of trade of less developed countries:

2.3.1 Causes of deteriorating terms of trade in LDCs

Nature of product

The less developed countries are mainly primary producing countries. Their exports mostly include primary products and their imports include capital goods. On the contrary, the developed countries produce and export manufactured goods. Thus the terms of trade between the primary products and manufactured products are generally determined against the former and in favour of the latter.

Effect of technical progress

Industrial countries keep the whole benefit of their technical progress, whereas the primary producing countries transfer a part of the fruits from their own technical progress to the industrial nations. Money incomes and prices have risen more rapidly than productivity in industrial countries,
whereas in the primary producing countries, the gains in productivity have been distributed in the form of price reductions. This has led to the deterioration of terms of trade of the primary producing countries.

Different market conditions

Export prices in the industrial countries do not fall as a result of technical progress because the manufacturers operate under monopolistic conditions in the product market; and they do not operate under competitive conditions in the factor market, i.e., labour market is dominated by trade unions. Thus,
the benefit of the improved technology is not transferred to the consumers in poor countries.
The producers in the poor countries, on the other hand operate under competitive conditions both domestically and internationally. Thus, as a result of technical progress in these countries, prices fall and the benefits flow to the consumers in the rich countries.

The prices of primary products rise sharply in the prosperous periods and fall in the downswing of the business cycle. In contrast, although manufacturing prices rise in the upswing of the
cycle, these do not fall so much in the depression because of the rigidity of industrial wages and price inflexibility due to monopolistic conditions. Thus, over successive cycles, the gap between the prices of the two groups of commodities has widened, and the primary producing countries have suffered an unfavourable movement in their terms of trade.

Disparity in demand

Declining terms of trade of the less developed countries is also due to longterm disparity in the demand for manufactured and primary products.

In the industrial countries, the income elasticity of demand for primary products is inelastic (i.e., less than one), while in the poor countries, the income elasticity of demand for manufactured goods is more elastic (exceeds one).

This is because, as incomes rise, the proportion of expenditure on food declines. Thus, the demand for food increases less rapidly than the rise in income and the demand for raw materials is restricted by competition from synthetic or man-made substitutes.

Backward technology

The less developed countries use backward technology as compared to the developed countries. As a result, their relative productivity is low, cost ratios are high, and price structure is also relatively high. This leads to the adverse terms of trade for the poor country, placing it at a disadvantageous bargaining position.

High population growth

Most of the less developed countries experience overpopulation and high population growth. As a result, there is high internal demand for the goods and low exportable surplus. Moreover, the import demand of these countries is highly inelastic. This causes their terms of trade to fall.

Lack of import substitutes

Poor countries are greatly dependent on the advanced countries for their imports and have not developed import substitutes. On the other hand, the advanced countries are not so much dependent on the poor countries because they are capable of producing import substitutes. Thus, the poor countries
have weak bargaining position in the international trade.

High transport costs

Rwanda being a land locked country and without cheap air or railway links to regional or international markets make it difficult for trade development in the country.

Unlike, the advanced countries, the less developed countries cannot quickly adapt their supply of goods which are high in demand and whose prices are

rising. The reasons for this are: backward technology, market imperfections, immobility of factors of production, etc. Thus, the terms of trade of less developed countries tend to deteriorate and
these countries fail to reap gains by increasing their supplies of exports during inflation.

Similarity of products

Most LDCs produce more less the same products which leads to limited market among themselves. They therefore tend to increase their export shares to MDCs by reducing prices, yet they have to continue importing manufactured goods from MDCs which are highly priced.

Political instability

Most LDCs lack a considerable manufacturing sector as a result of political instability and insecurities. This reduces the volume of manufactured commodities that would be exported.

Lack of diversification in production in LDCs

Most LDCs depend on a few traditional cash crops like tea, coffee, cotton tobacco, sisal, cocoa etc. which limits the amount of income they get from exports compared to developed countries that export to LDCs a wide variety of manufactured goods.

2.3.2 How to improve terms of trade for LDCs

Most LDCs face unfavourable terms of trade, an indication that LDCs do not favourably enjoy the benefits of international trade. LDCs should adopt any of the following policies in order to improve their terms of trade so as to enjoy more benefits from international trade.

LDCs should carry out market research so as get enough information to widen markets for their commodities. For example in Rwanda, the opportunity of having research institutions e.g. ISSAR, KIST, IRST have done a number of researches in Agriculture and Scientific technology. Many of these researches are market oriented and enables us to access new clients and overcome supply constraints domestically, regionally and internationally.

Human resource development

LDCs should develop a strong human resource through education and training so as to reduce expenditure on imported labourforce which is always expensive. For example, availability of skilled and semi-skilled labour in the country allows different types of people to be employed in many of the
existing sectors and then lead to economic development.

Promote peace and security

Due to instabilities in most LDCs, there is always fear by investors both local and foreign, therefore LDCs should ensure peace and security in all parts of their countries, for example, the prevailing peace and security in Rwanda presents a strong opportunity for trade development as the business men carry out their activities without fear of robbery or any other security risk.

Good governance

In most LDCs, there is financial indiscipline like corruption and embezzlement of government funds which normally affects productive sectors thus less productive capacity. In LDCs economies, trade is favoured
by the existence of good governance, for example in Rwanda, especially with the establishment of ombudsman, it has helped in fighting against corruption in all sectors which has promoted transparency and efficiency thus increased gains from trade.

Promoting regional integration and economic cooperation
among LDCs

LDCs should form economic groupings and trade among themselves in order to avoid exploitation by MDCs. For example, Rwanda is already a member to regional and international bodies like East African Community (EAC), Common Market for Eastern and Southern Africa (COMESA) and its free trade area and is able to access the whole market without any barriers to trade. Rwanda is also ready to benefit from various blocks like Economic Community for Central African States (ECCAS), African Growth
Opportunity Act (AGOA), African Union (AU), World Trade Organisation (WTO), European Union (EU), bilateral trade arrangements, etc. This offers Rwanda an opportunity for easy access to foreign markets.

Public - Private sector partnership

LDCs should promote the development of private sector so as to promote efficiency in production and increase the exploitation of idle resources which increases export volume. The government’s commitment to private sector development makes it an opportunity for trade development, as there are initiatives of creating conducive environment for trade thus increasing gains from international trade.

Different countries have different laws governing trade/business in their economies; this however limits opportunities to investment and trade.
Therefore, there should be an effort made on the establishment of business
legal reform task force mandated to reform all business laws; this will create
conducive legal environment for trade by both local and foreign investors
and will increase the gains form international trade among LDCs.

There should be establishment of financial sector task force with the mandate of solving all problems in the financial sector. This helps avail easy and cheap credit facilities to potential investors and business class which boosts their productive levels thus increasing the export base.

There should be establishment of the trade points which will provide all trade related information; this becomes an opportunity as trade information will be easily obtained in one place. This attracts different investors from within and outside the country’s economy thus promoting production directed towards export and or reducing import expenditure.

LDCs should enhance the establishment of permanent national and international trade fair grounds which creates an opportunity for trade development as it will give business men a chance of regular expositions
which will help them in the sell and advertisements of their products.

Business development centres (BDS) should be established. This will facilitate easy coordination of business activities in rural areas.

Export processing zone

Establishment of export processing zone which facilitate trade development in particular and development in general. This helps transform LDCs commodities into finished products so as to increase the export value and gains from trade as well.

Producer cooperatives and associations

LDCs should form producer cooperatives and associations to bargain for higher prices for their exports. Governments should take initiative in cooperatives development so as to create an opportunity for trade
development. From a strong cooperative movement, trade is improved.

Population control measures

LDCs should take up strong measures to control population growth e.g through family planning campaigns. Population control can increase on the level of exports.

Diversification of domestic production

LDCs should diversify their production so as to reduce dependency on few traditional exports where terms of trade are unfavourable and keep on fluctuating.

Import substitution strategy

LDCs should adopt import substitution strategy so as to minimise import expenditure.

Technological development

There should be the development and use of intermediate technology to reduce expenditure on expensive capital.

Activity 3

We have seen in Unit 1 Activities 1 and 2 that Rwanda exports and imports goods and services from different parts of the world. Using the knowledge gained and your own analysis, share among yourselves

(a) What economic term is given to the difference between export and import of goods in a country.

(b) What economic term is given to the difference between  export and import of services in a country.

(c) When is the balance of trade of a country said to be favourable and or unfavourable.

(d) What distinguishes balance of trade from balance of payment.

Facts

2.4.1 Meaning of Balance of Trade

Balance of Trade (BOT) is the difference in value over a period of time between a country’s imports and exports in tangible or visible commodities, usually expressed in the unit of currency of a particular country. The balance of trade denotes the difference of imports and exports of a merchandise
of a country during the course of a year. The trade balance is identical to the difference between a country’s output and its domestic demand (the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock,
nor does it factor in the concept of importing goods to produce for the domestic market).

The balance of trade is part of a larger economic unit, the balance of payments (the sum total of all economic transactions between one country and its trading partners around the world), which includes capital movements (money flowing to a country paying high interest rates of return), loan repayment, expenditures by tourists, freight and insurance charges, and other payments.

If the value of exports of a country over a period exceeds its value of imports, the country is said to have a favourable balance of trade, or a trade surplus. Conversely, if the value of total imports exceeds total value of its exports over a period, an unfavourable balance of trade, or a trade deficit, exists. A favourable balance of trade indicates good economic condition of a country.

A continuing surplus may, in fact, represent underutilised resources that could otherwise be contributing towards a country’s wealth, where they are to be directed toward the purchase or production of goods or services. Furthermore, a surplus accumulated by a country (or group of countries) may have the potential of producing sudden and uneven changes in the economies of those countries in which the surplus is eventually spent.

Generally, the developing countries (unless they have a monopoly on a vital commodity) have particular difficulty maintaining surpluses since the terms of trade during periods of recession work against them; that is, they have to pay relatively higher prices for the finished goods they import but receive
relatively lower prices for their exports of raw materials or unfinished goods.

The balance of trade forms part of current account on the BOP, which includes other transactions such as income from the net international investment position as well as international aid. If the current account is in surplus, the country’s international asset position increases correspondingly. Equally, a deficit decreases the country’s international asset position.

Table 1: Difference between Balance of Trade and Balance of Payments

2.4.2 Factors that can affect the balance of trade

• The cost of production (land, labour, capital, taxes, incentives, etc.)  in the exporting economy vis-à-vis those in the importing economy.

• The cost and availability of raw materials, intermediate goods and other inputs.

• Exchange rate movements.

• Non- tariff barriers such as environmental health or safety standards.

• The availability of adequate foreign exchange with which to pay for  imports.

• Prices of goods manufactured at home (influenced by responsiveness of supply).

• Multilateral, bilateral and unilateral taxes or restrictions in trade.

In 2014, the Rwandan economy recovered from the slowdown experiencedin 2013 recording a growth of 7.0 percent against a growth of 4.7 percent recorded in 2013.

Agriculture sector grew by 5.0 percent and contributed 1.6 percentage points to the overall GDP growth. Activities in the industry sector grew by 6.0 percent and contributed 0.9 percentage points to the GDP growth. The service sector increased by 9.0 percent and contributed 4.3 percentage
points to the GDP growth.

Rwanda recorded a trade deficit of 116.57 million USD in November 2016. Balance of trade in Rwanda averaged -216.59 million USD from1998 until 2016, reaching an all-time high of -100.62 million USD in October 2016 and a record low of -1268.30 million USD in December 2012.

The figure above shows Rwanda’s trade balance for the year 2016

Rwanda’s exports remained dominated by traditional products such as coffee, tea and minerals like tin, colton, wolfram and cassiterite. Rwanda’s main exports partners are China, Germany and United States. Rwanda imports mainly food products, machinery and equipment, construction materials, petroleum products and fertilisers. Main imports partners are Kenya, Germany, Uganda and Belgium.

2.4.4 Calculations of balance of trade

(a) Calculate visible balance for both years and interpret the answer.

(b) Calculate invisible balance for both years.

(c) Calculate the net capital inflows for both years.

(d) Determine the net transfers.

(e) Calculate the current balance.

(f) Assuming there are no errors and omissions, what is the balance
on monetary account in both years (M and N).

Exercise

Table 3: Study the table below and answer the questions that follow;

(a) Calculate visible balance for both years and interpret the answer.

(b) Calculate invisible balance for both years.

(c) Calculate the net capital inflows for both years.

(d) Determine the net transfers.

(e) Calculate the current balance.

(f) Assuming there are no errors and omissions, calculate the
balance on monetary account in both years (A and B) and

2.4.5 Causes of changes in the terms of trade

Activity 4

Think of a situation where a country’s terms of trade in some years are favourable and unfavourable in others, from the knowledge acquired on terms of trade in Activity 1 and 2 of unit 2, share your views in your class discussions about:

(a) The possible causes of changes in the terms of trade for  LDCs.

(b) The resultant consequences of changes in the terms of trade  on balance of trade.

Facts

Causes of changes in terms of trade in the short run and long-run include:

(a) Short-run

The terms of trade is the price relationship between a country’s exports and imports and will, therefore, be influenced by all the factors which determine the prices of imports and exports.

Fluctuations in exchange rates

In the short-run, changes in relative prices of imports and exports will be caused by fluctuations in exchange rates, particularly where countries operate a floating exchange rate system. Exchange rate instability may be caused by changes in trade, capital flows, interest rates, speculation, inflation and
use of foreign currency reserves by the government. You will recall that a depreciation of the exchange rate causes import prices to increase and export prices to decrease, while an appreciation causes the
opposite effects.

Fluctuation in the prices of commodities

Also in the short-run, there may be considerable fluctuation in the prices of commodities which will affect the terms of trade. This is particularly true for agricultural commodities, the supply of which is often affected by drought, floods, diseases, etc. Given that the demand for and supply of

these commodities is highly inelastic, the change in supply will cause a proportionately greater change in price.

(b) Long-run

In the longer term, changes in the terms of trade are likely to be determined by those factors which exert a long term influence on the demand for, and supply of, a country’s exports and imports.

For the developing countries, who export mainly primary goods and import manufactured goods, their export prices have tended to fall over time due to a combination of increased supply of and reduced demand for their exports.

Development of synthetic substitutes, e.g. plastics

This has lessened the demand for several raw materials from LDCs thus

Low income elasticity of demand for primary commodities

As real world incomes have grown, the demand for primary commodities has increased less than proportionately.

Agricultural protection

The developing countries, despite producing at lower cost, have found it difficult to break into the markets of the richer countries. As farmers they are often heavily subsidised and, in the case of the European Union, protected by a common external tariff.

Miniaturisation

Modern microchip technologies have enabled products to become smaller, e.g. the personal computer, and this has necessitated less use of raw materials and caused demand to fall.

Price inelastic demand for exports of primary commodities

Compounding the problem of falling export prices, demand for primary commodities tends to be price inelastic, such that decreases in prices bring about less than proportionate increases in the quantity demanded.

Change in factor endowments

Changes in factor endowments may increase exports or reduce them. With tastes remaining unchanged, they may lead to changes in terms of trade. Suppose there is an increase in Rwanda’s supply of factors of production

with constant change in tastes, its productive capacity would increase thus terms of trade would move towards Rwanda against Kenya.

Devaluation

Devaluation raises the domestic prices of imports and reduces foreign price of exports of a country devaluing its currency relative to the currency of another country.

Tariff

An import tariff improves the TOT of the imposing country, for example if a tariff is imposed on Rwanda’s tea by Kenya, the changes in terms of trade are in favour of Kenya. Since the quantity of exports of Rwanda reduce as a result of tariff by Kenya is greater than the quantity of imports by Rwanda,
the terms of trade definitely move in favour of Kenya.

Economic growth

The raising of a country’s national product or income overtime (economic growth) affects the terms of trade of a country. Given the tastes and technology in a country, an increase in its productive capacity may affect favorably or adversely its terms of trade. As a result of economic growth, a
country exports less that will bring much imports in the country.

Changes in tastes

Changes in tastes of people in a country also affect a country’s TOT with another country. Suppose Kenya’s tastes shift from Rwanda’s tea to its own coffee, in this situation, Kenya would export less coffee to Rwanda and its demand for Rwanda tea would also fall. Thus Kenya’s terms of trade would
improve. On the contrary, a change in Kenya’s taste for Rwanda’s tea would increase its demand and hence terms of trade would deteriorate for Kenya.

Changes in technology

As technology changes, terms of trade of a country increase or decrease respectively, for example, if Rwanda uses poor technology compared to Kenya, the terms of trade would be in favour of Kenya against Rwanda. This is because Rwanda would export less and import more in return from
Kenya. However, if Rwanda’s technology advances, it will be better off as it exports more of its tea hence improving the terms of trade.

2.4.6 Consequences of changes in the terms of trade on balance of trade

The terms of trade is the index of export prices divided by index of import
prices Px/Pm (*100)

An improvement in the terms of trade means that export prices are increasing faster than import prices. Therefore, there will be a fall in exports and an increase in quantity of imports. Therefore, it is likely that with lower exports the current account deficit (trade deficit) will get worse, i.e. bigger deficit.

However, it relies on the Marshall-Lerner Condition. If the Marshall-Lerner condition is satisfied, then an improvement in the terms of trade will worsen the current account.

The Marshall Lerner condition states that if demand for exports and imports is relatively elastic i.e. PED x + PED m >1, then an increase in terms of trade will worsen the current account (balance of trade).

Sometimes elasticity of demand varies over time. In the short term demand is often inelastic; in the longer term demand becomes more elastic. Therefore, we can often see a “J Curve effect”, where an improvement in terms of trade worsens current account in short term but improves in the long term.

If a country experiences deterioration in the balance of trade (value of imports increase faster than value of exports), then it may impact upon the terms of trade.

A deterioration in the balance of trade means a country is importing more than exporting. Therefore, more currency will be leaving a country. This would mean an increase in supply of franc and lower demand. Therefore, it is likely to cause devaluation. This would mean cheaper exports and more
expensive imports. We say this would be deterioration in the terms of trade.

However, other factors may be affecting the terms of trade. For example, it depends on whether there is a strong inflow on other aspects of the balance of payments like the trade in services of financial account (capital flows).

Also other factors can affect exchange rates like confidence, speculation and
relative interest rates. Therefore, in the short term a change in the balance

of trade doesn’t necessarily affect the terms of trade although in the long term it probably will.

Glossary

ཀྵཀྵ Balance of trade: The difference between the value of visible and  invisible exports and imports.

ཀྵཀྵ Barter terms of trade: The ratio of the quantity index of exports   to the quantity index of imports.

ཀྵཀྵ Deteriorating terms of trade: When a country experiences   unfavourable terms of trade for continuous years.

ཀྵཀྵ Favourable terms of trade: This refers to where a country’s  export prices are higher than her import prices.

ཀྵཀྵ Income terms of trade: The ratio of income earned from exports  to the price of imports.

ཀྵཀྵ Terms of trade: The measure of import purchasing power of a  country’s export or the relationship between the price of a  country’s export and its expenditure on imports.

ཀྵཀྵ Unfavourable terms of trade: This is when a country’s import  prices are higher than her export prices.

ཀྵཀྵ Visible balance: Is difference in value of a country’s physical   imports and exports over a period of time.

Unit summary

• Meaning

• Forms of terms of trade

• Nature of terms of trade in LDCs