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Impact of TOT

Consequences of a change in terms of trade - balance of payments and economy

Changes in the terms of trade will have a significant impact on an economy. For example, many developing countries are very dependent on exports of primary commodities - minerals, agricultural commodities like coffee etc. If prices of these commodities on world markets fall (as has been the case in recent years) then they face a deterioration in their terms of trade. They are earning less from the same volume of exports and this means that they cannot afford to import as much. Their standard of living has fallen, not because of anything they did, but simply due to the vagaries of world markets.

This shows us the main impact of changes in the terms of trade - the effect on the standard of living.

  • An improvement in the terms of trade may improve the standard of living in a country - the same volume of exports will buy more imports.
  • A deterioration in the terms of trade may reduce the standard of living as more exports have to be sold to pay for the same volume of imports.

However, we also need to take account of the impact on competitiveness of these price changes. If the terms of trade has improved, then this means that export prices have increased more than import prices. This may indicate a deterioration in competitiveness and in the medium term may lead to a fall in export demand. How much export demand falls will depend on the price elasticity of demand for exports. This may adversely affect the balance of payments.

In the same way, a deterioration in the terms of trade may indicate an improvement in competitiveness. This is because import prices have risen more than export prices, perhaps showing that exports are more competitive. In the medium term demand for exports may rise and lead to an improvement in the current account.

So, analysing the terms of trade is not a simple matter. Prices of imports and exports will constantly be changing according to supply and demand and the average changes in these prices will show up in the terms of trade. An improvement in the terms of trade may well be good news for exporters, but are they perhaps less competitive in the medium term as a result? For developing countries that are very dependent on a narrow range of primary exports, the terms of trade will be crucial to their ability to grow and to fund essential imports.