Cambridge International as and a level Economics Ebook

Causes of changes in the terms of trade
Essentially what causes a favourable movement in 
the terms of trade is a rise in export prices relative 
to import prices. For instance, export prices may 
rise by more than import prices or import prices 
may fall while export prices remain unchanged. An 
unfavourable movement occurs when there is a fall in 
export prices relative to import prices. In this case, for 
example, import prices may fall by less than export 
prices or import prices may rise while export prices 
may fall.
What leads to changes in export and import prices 
and so to changes in the terms of trade is changes in 
demand for and supply of exports and imports, the price 
level and the exchange rate. An increase in the demand 
for exports would increase their price and so cause a 
favourable movement in the terms of trade. A rise in a 
country’s relative infl ation rate would also make its export 
prices higher relative to its import prices. A devaluation is 
sometimes referred to as a deliberate deterioration of its 
terms of trade. Th
is is because it is a deliberate attempt to 
reduce export prices and raise import prices in order 
to make the country’s products more internationally 
competitive.
Th
e Prebisch-Singer hypothesis suggests that the terms 
of trade tend to move against primary producing countries. 
Th
is is based on the view that demand for manufactured 
goods and for services rises by more than demand for 
primary products when income increases. In recent years, 
the relative prices of some agricultural products have fallen 
but there has been more volatility in commodity prices, 
with some years witnessing signifi cant rises in the price of, 
for instance, oil and copper.
The impact of changes in the terms of trade
While a rise in the terms of trade is described as 
a favourable movement, its impact is not always 
favourable. Th
is is because its eff ects will depend on 
its cause. If the price of exports increases because of a 
rise in demand then it is likely to be benefi cial as more 
domestic products will be sold. If, however, the cause 
is a rise in the costs of production, demand for the 
country’s products will fall and export revenue may 
decline.
An unfavourable movement in the terms of trade may 
actually reduce a defi cit on the current account of the 
balance of payments. If the Marshall-Lerner condition 
is met, the fall in export prices relative to import prices 
should increase export revenue relative to import 
expenditure.
It is important to remember that the terms of trade is 
a measure of export and import prices and not export and 
import values.