Terms of trade — Edexcel A-Level Economics A
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Terms of trade explained
A country's terms of trade change when export prices or import prices change relative to each other.
Read the full explanation
Influences include: changes in global demand for exports, such as a rise in world demand for a commodity raising its price; changes in global supply of imports, such as new mining capacity lowering import prices; exchange rate movements, where a depreciation raises import prices in domestic currency and can worsen the terms of trade; domestic inflation raising export prices; productivity changes altering costs and prices; and trade policies such as tariffs or quotas. For example, if global demand for a country's main export rises, its export price index rises, so the terms of trade improve, provided import prices are unchanged. Always link the factor to either the export price index or the import price index, then state the effect on the ratio.
Your focus
- Identify factors that influence a country's terms of trade.
- Explain how a named factor changes export or import prices.
- Assess whether a factor improves or deteriorates the terms of trade.
Terms of trade exam tips
Marking Points
- Identifies a valid factor such as global demand for exports, global supply of imports, exchange rates, domestic inflation, productivity or trade policy.
- Explains how the factor changes the export price index or the import price index.
- Links the change in the price index to the terms of trade ratio, stating improvement or deterioration.
- Uses a concrete example, such as a rise in world demand for a commodity raising export prices and improving the terms of trade.
Examiner Tips
- 💡Name the factor, then state which price index it affects and in which direction.
- 💡Finish by stating whether the terms of trade improve or deteriorate.
- 💡Use a short example to make the chain of reasoning clear.
Common Mistakes
- Confusing a change in the terms of trade with a change in the balance of trade. Correction: the terms of trade concern relative prices, not the value or volume of trade.
- Assuming a depreciation always worsens the terms of trade. Correction: it raises import prices in domestic currency, which usually worsens the terms of trade, but the effect depends on export prices too.
- Ignoring the other price index. Correction: always consider both export and import prices because the terms of trade are a ratio.
- Treating a higher terms of trade value as always beneficial. Correction: a higher value means more imports per unit of exports, but the effect on the trade balance and welfare depends on volumes and demand elasticities.