Year 12

AQA A level Economics Terms of Trade Notes

Terms of Trade

— Economics · International Trade —

1. Three Key Trade Measures

Three ideas always appear together — don’t mix them up:

① Balance of Trade (BoT) XTR − MTE = Export Revenue − Import Expenditure

② Balance of Payments (BoP) Inflows − Outflows

③ Terms of Trade (ToT) Export prices relative to import prices

Where: X = exports | M = imports | XTR = export revenue | MTE = import expenditure | I = inflows | O = outflows
MeasureFormulaGood sideBad side
Balance of TradeXTR − MTEBoT Surplus → XTR > MTEBoT Deficit → MTE > XTR
Balance of PaymentsInflows − OutflowsBoP +ve → I > OBoP −ve → O > I
Terms of TradeIndex of X priceIndex of M price × 100ToT improves → X price ↑, M price ↓ToT worsens → X price ↓, M price ↑

2. What is Terms of Trade?

Definition: ToT is a measure of the index of export price to the index of import price, expressed in percentage form.

FormulaToT = Index of Export PriceIndex of Import Price × 100
1 unit of domestic good 1 unit of imported good exported in return
ToT compares what one unit of exports earns against the price of imports

1 unit of the domestic good is exported → in return we get 1 unit of imported good. Base year index = 100.

ToT Favourable / Improve
X price ↑ , M price ↓
ToT Adverse / Worsen
X price ↓ , M price ↑
For eg:
ToT index = 105, base year index = 100 ⇒ favourable movement of 5% (EP ↑ relative to IP).

3. Calculating ToT — Examples

Example 1 Export price index = 105 Import price index = 101 ToT = Index of X priceIndex of M price × 100 = 105101 × 100 ToT = 104% (current year)
Example 2 Export price index = 102 Import price index = 105 ToT = Index of X priceIndex of M price × 100 = 102105 × 100 ToT = 97% (current year)
Base year = 100%Current year = 104%ToT ↑ ⇒ improve / favourableX price ↑ , M price ↓
Base year = 100%Current year = 97%ToT ↓ by 3% ⇒ worsenX price ↓ , M price ↑
100 (base year) 97 (Ex 2) 104 (Ex 1) worsens improves
ToT index above 100 = improved, below 100 = worsened (scale not to size)

4. Causes of Changes in Terms of Trade

① Depreciation (exchange rate ↓)

DepreciationExchange rate ↓Exports sideImports sideX price ↓X qty ↑XTR ↑Inflows ↑M price ↑ → ToT worsens (X price ↓, M price ↑)M qty ↓MTE ↓ → BoT surplus → XTR > MTEOutflows ↓ → BoP +ve → I > O
depreciation → exports cheaper abroad, imports dearer ⇒ ToT worsens, BoT surplus, BoP +ve

② Inflation (prices ↑)

InflationDomestic prices ↑Exports sideImports sideX price ↑X qty ↓XTR ↓Inflows ↓M price ↓ → ToT favourable (X price ↑, M price ↓)M qty ↑MTE ↑ → BoT deficit → MTE > XTROutflows ↑ → BoP −ve → O > I
inflation → exports dearer, imports relatively cheaper ⇒ ToT favourable, BoT deficit, BoP −ve
Note: chains like X price ↑ → X qty ↓ → XTR ↓ (and the import side) assume demand is price elastic — quantity changes by a bigger % than price.

③ Demand for Exports and Imports

Changes in demand for exports or imports can also lead to changes in terms of trade.

④ Rising Productivity

PQ D S S₁ PP₁
supply shifts right ⇒ price falls

If productivity ↑ ⇒ cost of production ↓ ⇒ supply ↑ (shifts to the right) ⇒ prices ↓ ⇒ ToT worsens.

⑤ Tariffs

Tariff: a tax on imported goods — makes imports appear expensive, so import prices ↑ and ToT worsens.

Tariff = tax on imported goodsM price ↑ → ToT adverse (M price ↑, X price ↓)M qty ↓MTE ↓ → BoT surplus → XTR > MTEOutflows ↓ → BoP +ve → I > O
tariff → M price ↑ ⇒ ToT adverse, BoT surplus, BoP +ve

5. Quick Recap

✓ Full Cheat-Sheet — Terms of Trade
  • BoT = XTR − MTE → surplus (XTR > MTE) / deficit (MTE > XTR)
  • BoP = Inflows − Outflows → +ve (I > O) / −ve (O > I)
  • ToT = (Index of X price ÷ Index of M price) × 100, base year = 100
  • ToT ↑ = favourable → X price ↑, M price ↓  |  ToT ↓ = adverse → X price ↓, M price ↑
  • Ex 1: 105/101 × 100 = 104% (improves)  |  Ex 2: 102/105 × 100 = 97% (worsens by 3%)
CauseToTBoTBoP
Depreciationworsenssurplus (XTR > MTE)+ve (I > O)
Inflationfavourabledeficit (MTE > XTR)−ve (O > I)
Tariffworsenssurplus (XTR > MTE)+ve (I > O)
Rising productivityworsens (prices fall)——
Change in demand (X or M)changes ToT——