School Papers

Consequences average weighted price of exports increase too.

 

Consequences
of improving terms of trade (TOT) caused by domestic inflation.

A country’s terms of trade can be defined as measure of
a country’s export prices in relation to its import prices. It
is affected by several factors, for example: Changes in global level of demand
and supply, changes in exchange rate, relative inflation rate, etc. These
factors can cause improvement or worsening of terms of trade. If a country’s terms of trade improve, it means that for
every unit of exports sold it can buy more units of imported goods. i

As mentioned earlier, relative inflation rate can cause
change in terms of trade of an economy. If inflation rate in one country is
higher than in another then their exports prices will begin to rise which will
improve terms of trade. This is because as the general price rise, average
weighted price of exports increase too. But even if it caused improvement in
terms of trade it makes the export less competitive. In short run, as the
demand for exports might be less elastic which makes exports less responsive to
increase in price. However, in long run exports will be responsive towards
change in price which will lead to fall in exports worsening the terms of trade
itself and balance of trade. If exports fall it will lead to unemployment. For
example, the growth in car exports has created many jobs in car industries,
such as BMW factory in Oxford, and Nissan in Sunderland. And if there is increase
in general price level (inflation), they become less competitive in global
market and consumers who import are responsive to the price changes as
they can import from other competitors in global market. This leads to fall in
supply which results in unemployment. Fall in exports will not only cause
unemployment but also lead to lower economic growth or even negative economic
growth as export is component of aggregate demand. Falling exports causes fall
in aggregate demand and cause fall in economic growth. For example, the fall in
car exports in Sunderland will create unemployment in the local economy which
leads to reduced consumer spending which again leads to fall in aggregate
demand resulting in fall in economic growth of the economy. ii

Similarly, if country is having domestic inflation government
will try to increase interest rates which are likely to foreign investment.iii Higher foreign
investment is likely to increase the
demand for a country’s currency in order for them to invest which increases
demand of that currency which consequently leads to appreciation or revaluation
(increase in value of currency) which further leads to increase in export
prices. This will not only increase export prices but also lead to reduced
competitiveness of exports of that currency which again leads to worsening of
terms of trade.

 

 

 

 

 

 

 

 

Significance of deteriorating terms of trade (TOT) for
developing countries

A country’s terms of trade can be defined as measure of
a country’s export prices in relation to its import prices. If a
country’s terms of trade improve, it means that for every unit of exports sold
it can buy more units of imported goods.

Generally,
if a country’s terms of trade fall then it will have lower living standards and
less ability to import. Many developing countries are just dependent on exports
of few primary commodities for their export revenue. Terms of trade in developing
countries is declining because of the fall in price of primary commodities. Exports
of primary commodities tend to be income inelastic, so that, as world incomes
grow, there is a less than proportionate increase in demand for primary
commodities. This is in contrast to the demand for manufactures and services
which tend to be highly income elastic – as world incomes increase, there is a
more than proportionate increase in the demand for the latter. Thus, there has
been a constant upward demand pressure on the export prices of the rich
countries and a constant downward pressure on the export prices of the primary
goods of the developing countries.iv There
has been increase in supply of primary commodities due to increase in use of
fertilizers, machinery and scientific research and discoveries of artificial
replacement for primary commodities like synthetic fiber and plastics. Likewise,
huge supportive policies in developed countries have had damaging effect on
export of primary commodities of developing countries. In developing countries,
primary commodities producers are awared with subsidies which has led to
reduction in price of primary commodities and because of which it has also led
to dumping of primary commodities in developing countries which have had huge
impact on their exports as well as domestic market.  

As a result
of fall in price of primary commodities and decreasing competitiveness of
exports of developing countries (because of use technology and supportive
regulations) , average export prices of developing country is falling with the
fall in exports revenue. This has led to worsening of terms of trade. Worsening
of terms of trade in developing countries has had adverse effects. It has lead
to depreciation of current account. This is because with fall in exports, price
of imports has risen relative to price of exports. The goods that are imported
by developing countries are inelastic goods for example raw materials for
economic growth. Thus, in order to fund their import expenditure developing
countries have to sell more which pushes the prices of primary commodities further.
Likewise, in order to increase exports developing countries overuse their
resources which has resulted in negative externalities such as land
degradation, desertification, health hazards, deforestation, etc. With fall in
export revenue, developing countries have to fund their expenditure by taking
loans which increases their indebtedness. This turns into a cycle that will
push them further down the poverty line.

However, in
recent year with global regulations by international organizations like World
Trade Organization and change in preferences of use of bio fuel there has been
increase in prices of primary commodities such as crops. This is likely to help
developing country in short run to come out of the vicious cycle but in long
run prices of primary commodities are volatile. Thus, developing countries
should find should find a secondary commodity that they can produce in cheaper
prices and avoid specialization in primary commodities to ensure the
uninterrupted economic growth in long run.

 

 

References:

i Terms of trade,
www.economicsonline.co.uk/Global_economics/Terms_of_trade.html.

 

ii Pettinger, Tejvan. “Importance of exports to the economy.” Economics
Help, www.economicshelp.org/blog/7164/trade/importance-of-exports-to-the-economy/.

 

iii Investopedia. “How does inflation affect the exchange rate between
two nations?” Investopedia, 10 Jan. 2018,
www.investopedia.com/ask/answers/022415/how-does-inflation-affect-exchange-rate-between-two-nations.asp.

 

iv “Deteriorating TOT.” The significance of deteriorating
terms of trade for developing countries,
www.sanandres.esc.edu.ar/secondary/economics%20packs/international_economics/page_89.htm.