Terms of Trade Effect

Definition: The Terms of Trade is the average price of exports / by the average price of imports. It is a measure of a countries relative competitiveness.

  • If export prices rise relative to import prices we say there has been an improvement in the terms of trade. – A unit of export buys relatively more imports.
  • If import prices rise relative to export prices we say there has been a deterioration in the terms of trade.

Effect of Devaluation on Terms of Trade.

  • If a currency falls in value. Then we would expect to see an increase in the price of imports. (You would need to pay more in Pound Sterling to buy the same quantity of foreign goods)
  • The domestic price of Exports should remainĀ  unchanged, though the foreign currency price should fall. e.g. Germans should be able to buy British goods with less Euro.
  • Since July 2007, the value of Sterling has fallen approximately 20%. In this period import prices have risen by 15% (as you might expect)

toft-sterlingeoi

Source: B of E Publication Explanation of Stability of Terms of Trade
Ceteris Paribus, a fall in the exchange rate should reduce the terms of trade. However, in the UK’s experience the terms of trade has remained the same. This is because export prices have risenĀ  by 15%.

Similarly, the depreciation has not had a noticeable impact on reducing the current account deficit, as you might expect. This is partly due to the terms of trade remaining constant and not falling as expected

Why Have UK export Prices Risen?

  • Demand for UK exports is relatively inelastic. Therefore, a weaker Pound has encouraged exporters to put up their profit margins and increase their prices.
  • If demand for UK exports was more elastic, there would be more incentive to keep prices low and try and increase sales.
  • Supply is inelastic. The greater profitability of exports has so far not encouraged more firms to enter the market and reduce export prices. In the future, the greater profitability of exports may encourage higher supply in exports reducing profit margins and prices of exports.
  • UK exporters have been pricing in foreign currency price. If exporters set their price in fixed foreign currency price. Then a depreciation in the exchange rate would automatically lead to a higher sterling price to reflect the same foreign currency price.

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