This essay critically examines the factors that could cause a deterioration in a country's terms of trade using chains of analysis and evaluation points. Points include relative inflation rates, relative productivity and relative exchange rates.
Assess the factors that could cause a deterioration in a country’s terms of trade.
The terms of trade are defined as the ratio between average export prices and average
import prices. When a country’s average export prices rise or when average import prices
fall, this causes a worsening in a nation’s terms of trade.
One factor that could potentially cause a decline in a country’s terms of trade, may be the
changes in relative inflation rates. If an importing country trades with an exporting country
that is experiencing relatively higher inflation, this could cause an increase in average import
prices. Therefore, the importing country would experience a deterioration in the terms of
trade. On the other hand, if an exporting country experiences deflation, this will lead to a
fall in average export prices. Once again, causing the terms of trade to worsen. However,
the significance of relative inflation on the terms of trade depends upon the elasticity of
demand. If a country’s exports were to be elastic, then a fall in export prices will result in a
deterioration of the terms of trade, but an improvement in the balance of trade as the
demand for exports rises. Therefore, a deterioration of a country’s terms of trade may not
always negatively affect the nation.
Additionally, a change in relative productivity rates may worsen a country’s terms of trade.
An increase in productivity levels may lead to lower costs of production. Lower costs of
production might then result in lower prices for exports. Lower export prices could then
possibly cause a deterioration in the terms of trade. In order to maintain the same level of
imports, countries must export more goods and services otherwise the terms of trade will
worsen. However, increased productivity levels may lead to higher export levels as a result
of lower prices. Hence, this may potentially increase revenue for a country. This could
benefit the nation even though terms of trade have worsened. Although, this may only
occur if the demand for goods and services is elastic.
Lastly, changes in the relative exchange rate could have an effect on a country’s terms of
trade. If a country’s currency were to experience a fall in value, this would result in export
prices decreasing. This would then cause the terms of trade to deteriorate. On the other
hand, if an exporting nation saw an appreciation in their currency, this would negatively
affect the importing nation. This would lead to the price of imports becoming more
expensive thus worsening the terms of trading for the importing country, as a result of the
appreciation. However, if an exporting country’s currency depreciated, this may increase
international competitiveness. As goods become cheaper for other countries to import, this
may improve international competitiveness for the exporting country. For example, in 1992,
the UK benefitted from the Pound depreciating, as international competitiveness rose, even
though the nation’s terms of trade declined.
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