A country’s terms of trade is the ratio of its export price index to its import price index. Changes in terms of trade are sometimes used to indicate the direction of change in a country’s gains from trade. Sudden changes in a country’s terms of trade can affect its overall macroeconomic position. Significant improvements in a country’s terms of trade may lead to Dutch disease, where the economy faces the possibility of a recession despite the boom in its export sector.
Terms Of Trade And Comparative Advantage
David Ricardo’s theory of comparative advantage is the standard for determining the pattern of trade between countries. It does not, however, pin down the terms of trade. Instead, it provides upper and lower bounds on the terms of trade that will allow mutually beneficial trade to occur. In the typical 2-good, 2-country model, the upper and the lower limits of the terms of trade are the opportunity cost for producing the good in each market. This is because if a good is more expensive in international trade than in autarky, countries would be better off producing the good themselves and not engaging in international trade. Mutually beneficial trade can therefore only occur at a price ratio that is bounded by the domestic opportunity cost in each market.
The extent to which each country gains from international trade is determined by the world price. The closer this world price is to a country’s opportunity cost, the lower is its share of the gains from trade; the farther this world price is from a country’s opportunity cost, the greater is its share of the gains from trade.
To illustrate this, consider a 2-country, 2-good model where the home country has a comparative advantage in production of commodities and the foreign country has comparative advantage in the production of the manufactured good. The home country opportunity cost is four commodities for one manufactured product. The opportunity cost for its potential trading partner, the foreign country, is one commodity for one manufactured product.
The terms of trade for home country is the price of commodities, its export good, divided by the price of manufactured products, its import good. This pattern of trade is consistent with that predicted from the pattern of comparative advantage. Assuming that the price of commodities is $1, then the price of manufacturing good is $4. These prices are consistent with the opportunity cost in the home country. This gives a ratio of export price to import price of 1/4. This ratio places a lower limit on the price at which the domestic economy is willing to engage in international trade. Further, at a terms of trade of 1/4, the home country does not gain from trade. This means that all the gains from international trade are captured by the second country.
The upper limit on the terms of trade is set by the foreign country’s willingness to trade. As was the case with the domestic economy, this reflects the opportunity cost in the foreign country. In this instance, the upper limit on the terms of trade is 1, because the foreign country is not willing to trade at higher prices. At terms of trade of 1, where the terms of trade is measured relative to the home country’s export good, the foreign country does not gain from trade. This means that all the gains from international trade are captured by the home country.
The terms of trade for the home country must lie between 1/4 and 1. The observed terms of trade is determined by demand for both goods in each country. If consumers have a strong preference for a country’s export good, then this will tend to drive up the price of their exports.
Assume that the initial terms of trade for the home country is 1/2. There is an exogenous shock that causes an increase in the price of commodities, while the price of manufacturing goods remains unchanged. This is reflected in the home country’s terms of trade, which increases from 1/2 to 3/4. With this improvement in the terms of trade, the home country captures more of the gains of trade. If instead, the exogenous shock caused a decrease in the price of commodities while the price of manufacturing goods remained constant, then the home country’s terms of trade would have deteriorated. This is reflected in the movement in the home country’s terms of trade from 1/2 to 1/3. With this deterioration in the home country’s terms of trade, the international division of the gains from trade moves in favor of the foreign country and the domestic economy captures less of the gains from trade.
Generalizing the lessons from the 2 x 2 model, it can be concluded that countries experiencing an improvement in their terms of trade can purchase more imports with the same amount of exports. This occurs whenever the price of a country’s exports rises by more than the price of its imports. Countries experiencing deterioration in their terms of trade can purchase less imports with the same amount of exports. This occurs whenever the price of a country’s exports rises by less than the price of its imports.
Based on the foregoing, the direction of changes in a country’s terms of trade over time is often used as a proxy for changes in its gain from trade. This is, however, only one source of potential gains from international trade, and caution should be exercised when trying to interpret the terms of trade in this manner.
Terms Of Trade Adjustments
The degree of control that countries have over their terms of trade is dependent on the nature of their export goods. Countries that produce differentiated products have more control over the world price of their exports than do countries that produce commodity products. This is consistent with economic theory, where differentiated product firms have market power and firms with undifferentiated products do not. Developing countries, because their exports are often dominated by undifferentiated commodity products, have little control over their terms of trade.
This is particularly true for sub-Saharan countries where exports are dominated by primary products. As a consequence, changes in world demand or in supply conditions elsewhere, which cause fluctuations in world commodity prices, will impact their terms of trade.
Another factor that affects the ability of countries to control their terms of trade is the size of country. In particular, large countries can use tariffs, that is, import taxes, to affect their terms of trade. A country is considered large if it accounts for a significant share of world demand, as reflected in its ability to change world prices through its trade policy actions. To influence its terms of trade, a large country would impose a tariff on imports, and this would result in a fall in the world price of the large country’s import goods. Because the price of the exports remains unchanged, the large country would have improved its terms of trade through the imposition of tariffs. However, very few countries are sufficiently large enough to use trade policy to influence their terms of trade. For those countries that are large enough to improve their terms of trade through trade policy, this choice is often not available because of the network of international agreements, principally the World Trade Organization (WTO) agreement, which limits these countries’ ability to increase tariffs.
For most countries, terms of trade shocks, that is, unanticipated changes in relative price of a country’s exports, are outside their control. If these terms of trade shocks are large, then it is possible for these effects to spill over into the broader economy and affect the country’s income levels.
Consider what happens if the terms of trade shocks are negative, such that the price of exports falls while the price of imports remain unchanged. Such a shock would cause the country’s export earnings to fall. Falling export earnings may reduce the income of agents in the export sector, which may be transmitted throughout the broader economy, resulting in a reduction in gross domestic product (GDP). If, instead, the price of exports increases, while the price of imports remain unchanged, then the terms of trade shock will be positive. Such a shock will cause the country’s export earnings to rise. Higher export earnings may increase the income of agents in the export sector, which may be transmitted throughout the broader economy, resulting in an increase in GDP.
For commodity-intensive exporters, changes in world demand or in supply conditions that cause fluctuations in world commodity prices will impact their terms of trade. This raises the potential for significant variability in these countries’ GDPs in response to the variability in world commodity prices.
Terms Of Trade Adjustment And Exchange Rates
The ability of countries to adjust in the face of terms of trade shocks is influenced by various factors. One important factor is the country’s exchange rate regime. There are two principal exchange rate regimes: flexible exchange rates and fixed exchange rates. With flexible exchange rates, demand and supply of foreign currency determines the price of foreign currency, that is, the exchange rate. With fixed exchange rates, the value of the country’s currency is pegged to a foreign currency or basket of currencies. To maintain this fixed price, the monetary authorities stand ready to purchase or sell foreign currency as needed to remove excess supply or augment market supply as may be needed.
Countries with flexible exchange rates are better able to adjust to terms of trade shocks than are countries with fixed exchange rates. This occurs because the flexible exchange rate regime provides a secondary adjustment mechanism that dampens the impact of the change in export earnings. In contrast, when the exchange rate is fixed, there is no secondary adjustment mechanism available to absorb some of the impact on the economy. Consider a country that is an exporter of primary products and that imports a range of essential products. Suppose that this country experiences a terms of trade deterioration as a result of a reduction in its export price.
This will decrease export earnings and, as a result, the amount of foreign exchange that is available also decreases. If the exchange rate is fixed, then the monetary authorities will absorb the shortfall in foreign exchange earnings, and the price of tradables will remain unchanged. If the exchange rate is flexible, then the shortfall in foreign exchange earnings will be reflected in its price and the country’s exchange rate will depreciate. This depreciation causes the price of tradables to increase. It is the adjustment in the price of tradables that leads to different adjustment patterns under fixed and flexible exchange rates.
With flexible exchange rates, tradable goods become more expensive. This makes exporting more attractive because the domestic currency equivalent that is received by exporters increases. This also makes importing less attractive because the domestic currency equivalent increases. This results in an increase in imports and potential substitution as formerly imported goods are replaced by domestic production. These changes serve to compensate for some of the income lost because of the fall in the country’s export price.
With fixed exchange rates, there is no subsequent change in the price of tradables. This means that there is no further change in the incentives to export and no incentives to substitute domestic production for imports. In short, there are no compensating expansions to offset the contraction resulting from the fall in export earnings. In summary, the extent of the adjustment in GDP in response to deterioration in a country’s terms of trade will differ under flexible and fixed exchange rates. With flexible exchange rates, the GDP response will be less significant than when exchange rates are fixed.
Suppose that instead the country experiences a terms of trade improvement. This will increase export earnings, and as a result, the amount of foreign exchange that is available increases. If the exchange rate is fixed, then the monetary authorities will accommodate the excess supply of foreign exchange earnings, and the price of tradables will remain unchanged. If the exchange rate is flexible, then the boom in foreign exchange earnings will be reflected in its price and the country’s exchange rate will appreciate. This causes the domestic currency price of tradables to decrease because each unit of domestic currency buys more foreign currency than previously.
With flexible exchange rates, tradable goods become less expensive. This makes exporting less attractive because the domestic currency equivalent that is received by exporters decreases. This also makes importing more attractive because the domestic currency equivalent increases. This results in a decrease in imports and potential substitution as formerly domestically produced goods are replaced by imports. These changes serve to dampen the GDP expansion effect sparked by the increase in export earnings. With fixed exchange rates, there is no change in the price of tradables. This means that there is no further change in the incentives to export and no incentives to substitute imports for domestic production. In short, there are no built-in stabilizers to constrain the economic expansion resulting from the rise in export earnings. In summary, the extent of the adjustment in GDP in response to improvements in a country’s terms of trade will differ under flexible and fixed exchange rates. With flexible exchange rates, the GDP response will be less significant than when exchange rates are fixed.
As explained above, the GDP response to terms of trade changes is larger under fixed exchange rates than under flexible exchange rates, independently of the direction of change in a country’s terms of trade. This means that primary exporters who adopt fixed exchange rates will have significantly more variability in their GDP than primary exporters who adopt flexible exchange rates.
Improvements In The Terms Of Trade And Dutch Disease
As previously noted, improvements in a country’s terms of trade will often translate into economic growth, as the boost in export earnings is transmitted through the remainder of the economy. However, large increases in the price of a country’s natural resource exports may have an adverse economic effect. This effect is known as Dutch disease, named after the observed negative economic effect experienced by the Netherlands following the discovery of natural gas in the 1960s. In the case of the Netherlands, the discovery of natural gas reduced the competitiveness of the Netherlands’ traditional export sectors, causing them to contract.
A better understanding of Dutch disease can be gained through the use of a simplified version of the model originally developed by W. M. Corden and J. Peter Neary in the 1980s to explain this disease. In this model, the production side of the economy is comprised of three sectors: two of them produce exports, and one of them produces a nontraded good. The export goods produced are a traditional export good and a natural resource. Suppose that the world price of the natural resource good increases by a significant percentage, while the world price of the traditional export remains unchanged. Consistent with the earlier analysis, the higher world price for the country’s export good will result in increased export earnings.
The higher world price for the natural resource good encourages expansion of this sector. This expansion is achieved by pulling resources away from the other sectors in the economy.
The increased earnings resulting from the export boom will be spent either on imports or on nontraded goods. If the demand for nontraded goods rises in response to the export boom, then the price of nontraded goods will increase. This increases the attractiveness of this sector, which expands to serve the now higher demand. This expansion is achieved by pulling resources away from other sectors in the economy.
When two of three sectors, namely, the natural resource sector and the nontraded good sector, demand more resources, these resources must be released from the third sector, that is, the traditional export sector. As a result, the output of the traditional export sector contracts.
An exchange rate effect is also at play here. When exchange rates are flexible, the traditional export sector is further hurt by the appreciation of the domestic currency. Such appreciation further decreases the attractiveness of traditional exports and causes a further contraction of this sector. When exchange rates are fixed, there are no secondary price effects in the traditional export sector, and as a result, its contraction is less severe than with flexible exchange rates.
The Dutch disease phenomenon has been observed in various circumstances, including the discovery of North Sea oil for the United Kingdom, the first oil price shock of the 1970s, and the substantial increase in coffee prices in the 1970s, following the failure of the Brazilian coffee harvest. More recently, the increases in copper prices and in the prices of crude oil in the 2000s have raised concerns as to whether Dutch disease is at play in economies that are major exporters of copper and oil.
- Marianne Baxter and Michael A. Kouparitsas, What Causes Fluctuations in the Terms of Trade? (National Bureau of Economic Research, 2000);
- Christian Broda and Cedric Tille, “Coping with Terms-of-Trade Shocks in Developing Countries,” Current Issues in Economics and Finance (v.9/11, 2003);
- Paul Cashin and Catherine Pattillo, “The Duration of Terms of Trade Shocks in Sub-Saharan Africa,” Finance and Development (2000);
- Christine Ebrahim-Zabeh, “Back to Basics—Dutch Disease: Too Much Wealth Managed Unwisely,” Finance and Development (v.40/1, 2003);
- Ippei Fujiwara and Naohisa Hirakata, Dynamic Aspects of Productivity Spillovers, Terms of Trade and the “Home Market Effects” (Institute for Monetary and Economic Studies, Bank of Japan, 2007);
- Norbert Funke et al., Terms of Trade Shocks and Economic Recovery, IMF Working Paper WP/08/36 (International Monetary Fund, 2008);
- Jaime Guajardo, Business Cycles in Small Developed Economies: The Role of Terms of Trade and Foreign Interest Rate Shocks (International Monetary Fund, 2008);
- Bill Wan-Sing Hung and Chung-Yin Tam, The Adjustment Speed and Improvement of the Terms of Trade in Asian Economies after the Financial Crisis (Hong Kong Baptist University, 2002);
- Timothy Jerome Kehoe and Kim J. Ruhl, Are Shocks to the Terms of Trade Shocks to Productivity? (National Bureau of Economic Research, 2007).
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