Summary
The terms of trade refer to the ratio of export prices to import prices, expressed as an index. Changes in the terms of trade can affect a country's export revenues, living standards, and balance of trade.
- Index of Terms of Trade — a measure comparing the average price of exports to the average price of imports. Example: If the export price index is 110 and the import price index is 105, the terms of trade index is 110/105 = 1.0476.
- Price Elasticity of Demand — the responsiveness of the quantity demanded to a change in price. Example: If export prices rise and exports are price elastic, the volume of exports may fall significantly.
- Exchange Rate — the value of one currency for the purpose of conversion to another. Example: A higher exchange rate can make imports cheaper, improving the terms of trade.
Exam Tips
Key Definitions to Remember
- Index of Terms of Trade
- Price Elasticity of Demand
- Exchange Rate
Common Confusions
- Confusing terms of trade with balance of trade
- Misunderstanding the impact of exchange rate changes on import and export prices
Typical Exam Questions
- How do you calculate the index of terms of trade? Divide the export price index by the import price index.
- What happens to the balance of trade if export prices rise and exports are price elastic? The balance of trade may deteriorate as export volumes fall significantly.
- How does a depreciation of a currency affect import prices? It generally increases import prices, potentially worsening the terms of trade.
What Examiners Usually Test
- Understanding of how to calculate and interpret the terms of trade index
- Effects of changes in the terms of trade on a country's economy
- Impact of exchange rate fluctuations on trade