Terms of trade (HL only)
Introduction
This lesson introduces the concept of terms of trade which some IB students confuse with the balance of payments or the current account. Many IB students also assume that an improvement in the terms of trade is automatically a positive event for an economy. In reality this may not be the case.
Terms of trade is a significant concept in the international trade section of the course but will also be used in the section on development. Remind students that they will be rewarded if they successfully link an economic concept from one part of the course to another, in either the IA commentary or the final exam.
Enquiry question
Understand the term terms of trade and distinguish between an improvement and a deterioration in the terms of trade. Understand the short and long term circumstances in world trade that bring about changes in a nation's terms of trade.
Lesson time: 1 hour
Lesson objectives:
Explain the meaning of the terms of trade and explain how the terms of trade are measured.
Distinguish between an improvement and a deterioration in the terms of trade.
Calculate the terms of trade using the equation: Index of average export prices/index of average import prices x 100.
Explain that the terms of trade may change in the short term due to changes in demand conditions for exports and imports, changes in global supply of key inputs (such as oil), changes in relative inflation rates and changes in relative exchange rates.
Explain that the terms of trade may change in the long term due to changes in world income levels, changes in productivity within the country and technological developments.
Teacher notes:
Key terms:
Current account - measures a country's balance of trade plus net income and direct payments.
Terms of trade - measures the relationship between export prices and import prices.
The activities on this page are available as a PDF at: terms of trade
Activity 1: Terms of trade
Use the information in the following video to answer the questions that follow:
(a) What are the terms of trade?
(b) What is the formulae for calculating the TOT?
(c) Explain the difference between an improvement and a deterioration in the TOT?
(d) Why might a nation's TOT rise?
(e) Why might a nation's TOT worsen?
(f) When a nation's TOT worsens, is this a positive or negative development?
(g) Why is the TOT of most Developed nations more stable (Australia excepted) than a LEDC such as Zambia.
Activity 2: Measuring terms of trade
A nation's terms of trade measures the relationship between export prices and import prices and is measured by the formulae:
Weighted index of average export prices / Weighted index of average import prices
The following terms of trade illustrates a nation's terms of trade.
Year | Index of export prices | Index of import prices | Terms of trade |
2013 | 100 | 100 | 100 |
2014 | 102 | 101 | |
2015 | 104 | 101 | |
2016 | 108 | 102 |
(a) Complete the missing blanks in the table.
(b) Why do economists use a weighted index to measure the level of export and import prices?
(c) Has the nation's TOT improved or worsened?
Activity 3
Year | Index of export prices | Index of import prices | Terms of trade |
2011 | 100 | 100 | |
2012 | 101 | 100 | |
2013 | 105 | 102 | |
2014 | 104 | 99 | |
2015 | 110 | 95 |
(a) Complete the following table by filling in the missing blanks:
(b) Explain the change in the terms of trade for the selected country and suggest possible reasons why this may have happened.
Activity 4: A focus on Russia
Watch the following 1 minute, 30 second video and then answer the following questions, based on the prediction made in the video.
(a) How are the terms of trade for Russia and other oil producing nations likely to be affected by the prediction.
(b) The TOT of China, India and EU.
(c) Explain the likely impact on the value of the Russian ruble?
Activity 5: A focus on Australia
(a) Calculate the % rise in the Australian terms of trade in the period 2000 - 2013.
(b) Provide possible reasons for this increase?
Activity 6: Terms of trade in Africa
Will the following bring an improvement to the terms of trade or a worsening?
- a higher rate of inflation than a country's trading partners
- a fall in income levels in the economy
- a severe shortage for one of the nation's main exports, caused by a failed harvest. This has increased the unit price of the product but reduced its supply by a much larger amount
- a sustained period of falling economic activity, which has reduced demand for imports of expensive luxury products but increased demand for low priced basic items
- A fall in the value of a domestic currency
- a fall in the selling price of one of the country's main exports due to a fall in its popularity
- a fall in inflation in the economy, relative to its main trading partners
- the discovery of a new raw material which is in demand overseas and can be sold for a high price
- a rise in investment in new technology which has allowed the LEDC to start producing and then exporting expensive luxury televisions and smart phones for the first time