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:

1. Beginning activity - begin with the opening video and then discuss this as a class.  (Allow 10 minutes in total)

2. Processes - technical vocabulary - the students can learn the background information from the video, completing activity 1 and the list of key terms.  (15 minutes)

3. Apply the theory - activities 2 and 3 are paper three in type and require simple calculations and discussion. (15 minutes)

4. Developing the theory - activity 4 and 5 contains short answer questions on Russia and Australia.  (10 minutes)

5. Reinforcement / reflection - activity 6 consists short answer responses which bring the page together, reflecting on whether the given changes to an economy (positive or negative) will bring about an improvement or deterioration in the TOT.   (10 minutes)

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?

It illustrates the index of export prices / index of import prices.

(b) What is the formulae for calculating the TOT?

Terms of trade (TOT) = weighted index of average export prices / weighted index of average import prices.

(c) Explain the difference between an improvement and a deterioration in the TOT?

An improvement in a nation's TOT means that the index of exports prices rises at a faster rate than the index of import prices.

(d) Why might a nation's TOT rise?

A nation might be exporting more products from higher valued added industries or there might be a rise in demand for your products which increases their price, there might be an appreciation of the nation's exchange rate.  Alternatively a nation's import prices might have fallen e.g. perhaps the products they are buying cost less, perhaps tariffs on the nation's export markets have disappeared.

(e) Why might a nation's TOT worsen?

Other nations might have started producing similar products to the nation, forcing down prices.   An improvement in technology may have forces down prices of some of a nation's exports, the exchange rate may have depreciated or shortages of a product that a nation imports may have forced up the purchasing price.

(f) When a nation's TOT worsens, is this a positive or negative development?

When a nation's TOT worsens they have to sell more exports to purchase the same number of imports.  This may be positive or negative depending on the circumstance.

(g) Why is the TOT of most Developed nations more stable (Australia excepted) than a LEDC such as Zambia.

Generally speaking the currency value of LEDCs will be less stable than exchange rates in Developed nations, plus their export prices are often heavily dependent on the price of one primary export e.g. Zambia's TOT is derived primarily from the world copper price.

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.

YearIndex of export pricesIndex of import pricesTerms of trade
2013100100100
2014102101
101
2015104101
103
2016108102
106

(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?

The figures are weighted to reflect the relative importance of different products traded by a country. 

(c) Has the nation's TOT improved or worsened?

By 2016 the average weighted export price has risen by 8%, while the average weighted import price rises by just 2%.  This means that the terms of trade for the nation improved, or in other words the country's exports were able to purchase more imports than previously.

Activity 3

Terms of trade for a selected country

YearIndex of export pricesIndex of import pricesTerms of trade
2011100100

100

2012101100

101

2013105102

103

201410499

105

201511095

116

(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.

There has been a gradual rise in the nation's terms of trade which could have been due to a number of factors, e.g.

  • a rise in the exchange rate which will have increased export prices and reduced import prices
  • an increase in the price of one or more of their main exported products
  • a decrease in the price of one or more of their main imported goods and services
  • a higher average rate of inflation in the country, relative to their main trading partners which, over time, will raise export prices and reduce import prices.

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.

A fall in oil prices will lead to significant deterioration on those nation's TOT.

(b) The TOT of China, India and EU.

Their TOTs are likely to improve as one of their primary imports becomes cheaper to purchase.

(c) Explain the likely impact on the value of the Russian ruble?

The Ruble and the currencies of many other oil producing nations will come under intensive downward pressure.

Activity 5: A focus on Australia

(a) Calculate the % rise in the Australian terms of trade in the period 2000 - 2013.

Calculated by 34 / 52 x 100 = 65%

(b) Provide possible reasons for this increase?

A significant factor has been the sharp appreciation of the Australian $ relative to the USA $, during this time period.  Between 2000 and 2013, the Australian $ witnessed a 50% rise in its value relative to the US$, much of the reason for this being a rise in demand for commodities, which the country produces in abundance.

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

an improvement to the nation's terms of trade as export prices rise

  • a fall in income levels in the economy

an improvement in the terms of trade as domestic demand for luxury goods and services falls and demand for cheaper imports rises

  • 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

an improvement to the nation's terms of trade

  • 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

an improvement to the nation's terms of trade

  • A fall in the value of a domestic currency

a worsening of the terms of trade as export prices fall and import prices rise

  • a fall in the selling price of one of the country's main exports due to a fall in its popularity

a worsening of the terms of trade as export prices will fall

  •  a fall in inflation in the economy, relative to its main trading partners

a worsening of the terms of trade as export prices will fall

  • the discovery of a new raw material which is in demand overseas and can be sold for a high price

an improvement to the nation's terms of trade

  • 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

an improvement to the nation's terms of trade

All materials on this website are for the exclusive use of teachers and students at subscribing schools for the period of their subscription. Any unauthorised copying or posting of materials on other websites is an infringement of our copyright and could result in your account being blocked and legal action being taken against you.