key term - Terms of Trade

Definition

The terms of trade refer to the ratio of a country's export prices to its import prices. It measures the exchange rate at which a country's goods are traded for goods from other countries. The terms of trade are an important indicator of a country's economic performance and its ability to purchase imports with its export earnings.

5 Must Know Facts For Your Next Test

1. The terms of trade are an important determinant of a country's standard of living, as they affect the purchasing power of its export earnings.
2. An improvement in a country's terms of trade (i.e., a rise in the ratio of export prices to import prices) allows it to purchase more imports with the same amount of exports.
3. Factors that can affect a country's terms of trade include changes in global demand and supply, technological advancements, and exchange rate fluctuations.
4. A country with a comparative advantage in the production of goods with high income elasticity of demand is likely to experience an improvement in its terms of trade over time.
5. The terms of trade can have significant implications for a country's trade balance and its overall economic performance, as they influence the country's ability to finance its imports and service its external debt.

Review Questions

• Explain how the terms of trade are related to a country's trade balances in historical and international contexts.
  • The terms of trade are closely linked to a country's trade balances, both historically and in an international context. An improvement in a country's terms of trade (i.e., a rise in the ratio of export prices to import prices) allows it to purchase more imports with the same amount of exports, potentially leading to a trade surplus. Conversely, a deterioration in the terms of trade can contribute to a trade deficit, as the country's export earnings may not be sufficient to finance its import spending. The terms of trade are influenced by various factors, such as global demand and supply, technological advancements, and exchange rate fluctuations, and can have significant implications for a country's standard of living and overall economic performance.
• Describe how the terms of trade are related to the flows of financial capital between countries.
  • The terms of trade can have a significant impact on the flows of financial capital between countries. A country with favorable terms of trade, meaning its export prices are high relative to its import prices, will be able to earn more from its exports and potentially accumulate a trade surplus. This surplus can then be invested in other countries, leading to outflows of financial capital. Conversely, a country with unfavorable terms of trade may experience a trade deficit, which would need to be financed through borrowing or attracting foreign investment, resulting in inflows of financial capital. The relationship between the terms of trade and financial capital flows is complex and can be influenced by factors such as exchange rate movements, global economic conditions, and the relative economic power of the trading partners.
• Analyze the role of the terms of trade in the context of a country's absolute and comparative advantages, and how this affects the tradeoffs of trade policy.
  • The terms of trade are closely tied to a country's absolute and comparative advantages in international trade. A country with an absolute advantage in the production of certain goods can leverage this to improve its terms of trade, as it can sell its exports at higher prices relative to the cost of its imports. Similarly, a country with a comparative advantage in the production of goods with high income elasticity of demand is likely to experience an improvement in its terms of trade over time. The terms of trade, in turn, can have significant implications for a country's trade policy and the tradeoffs it faces. For example, a country with favorable terms of trade may be more inclined to pursue free trade policies, as it can benefit from increased access to foreign markets and a higher purchasing power for its exports. Conversely, a country with unfavorable terms of trade may be tempted to implement protectionist measures, such as tariffs or quotas, in an effort to improve its trade balance and terms of trade, though this may come at the cost of reduced economic efficiency and consumer welfare.

Related terms

Trade Balance:

The trade balance is the difference between the value of a country's exports and imports. A positive trade balance indicates a trade surplus, while a negative trade balance indicates a trade deficit.

Comparative Advantage:

Comparative advantage refers to a country's ability to produce a good at a lower opportunity cost compared to another country. It is the basis for international trade and the gains from trade.

Absolute Advantage:

Absolute advantage refers to a country's ability to produce a good more efficiently than another country, using fewer inputs of labor and resources.