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. Generally, this leads to an improvement in living standards as imported goods appear cheaper to consumers.
- If import prices rise relative to export prices, we say there has been a deterioration in the terms of trade. Generally, this leads to a decline in living standards as foreign currency earnings are relatively less and imported consumer goods more expensive.
Effect of a devaluation on the 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 remain unchanged, though the foreign currency price should fall. e.g. Germans should be able to buy British goods with less Euro.
- Therefore, after a devaluation, you would expect to see a deterioration in the terms of trade.
- Since July 2007, the value of Sterling has fallen approximately 20%. In this period import prices have risen by 15% (as you might expect)
Effect of an appreciation on the terms of trade
- An appreciation will make imports cheaper. But, exports will become more competitive.
- Therefore, after an appreciation, you would expect to see an improvement in the terms of trade.
Factors that affect the terms of trade
- Exchange rate. A fall in the exchange rate should reduce the terms of trade. This is because a decline in the exchange rate will make exports cheaper.
- An appreciation in the exchange rate should improve the terms of trade because exports will rise in price and imports become cheaper.
- Competitiveness of firms. Export prices will be affected by the cost of raw materials and productivity.
- Relative inflation rates in different countries. Higher UK inflation would cause (at least temporary) improvement in the terms of trade as UK export prices would be rising faster than import prices. (Though inflation is likely to cause a depreciation in the exchange rate, which will cause exports to then fall in price.)
- Profit margins – do firms pass the effects of devaluation on to consumers in the form of lower prices? It is possible that movements in the exchange rate do not have the expected effects on the terms of trade. Rather than cut import prices, firms may keep prices the same.
UK terms of trade and Sterling exchange rate
Source: B of E Publication Explanation of Stability of Terms of Trade
- The appreciation in the Sterling exchange rate index between 1990 and 2005 caused a rise in terms of trade.
- The rapid devaluation in Sterling at the start of 2008, only caused a modest fall in the terms of trade.
Why did the UK terms of trade not deteriorate as expected in 2008?
- Demand for UK exports is relatively inelastic. Therefore, a weaker Pound has encouraged exporters to put up their profit margins and increase their prices rather than cut prices
- If demand for UK exports was more elastic, there would be more incentive to keep prices low to 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 at a 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.