An important statistic in the economics of international trade is the “Terms of Trade.” The terms of trade are the ratio between export prices and import prices. In other words, the terms of trade is a relative value that tells us how many goods from other countries we can buy for each dollar of exports. A country’s terms of trade improves (increases) when export prices increase relative to foreign prices; people can now buy more goods from abroad while giving up fewer exports. Conversely, a country’s terms of trade decline (get smaller) when the price of imports rises relative to the price of exports; people have to pay more in exports to import the same amount of goods.
For example, let’s say we have two countries: Whitebreak and Faltera. Whitebreak exports wheat and imports artwork (and vice versa for Faltera). Wheat sells for $1 and artwork sells for $1. The terms of trade in this first case are 1. Now suppose the price of wheat doubles to $2. Whitebreak’s trade terms improve to 2 ($2 wheat / $1 art). Selling the same amount of wheat can now buy 2 pieces of art. Whitebreak’s trading terms have improved. Conversely, Faltera now has to give up two pieces of art to buy the same amount of wheat.
Trading terms have improved in Whitebreak, but this citizens Whitebreak made better? It may be tempting to say, “Yes! They can buy more for the same amount of resources. Yes, they live better!” As readers of the title of this piece have probably already figured out, that answer is wrong. Why The changed values tell us more about whether the Whitebreak population is better or not. As Scott Sumner would say, never think about price changes.
There are two reasons why the price of a good can change: a change in demand for that good or a change in supply. If demand increases and the price of wheat increases, the people of Whitebreak are made better off: the amount of wheat used in the world increases and the economic surplus generated from the wheat market increases. In addition, as Falterans buy more, they sell more art in Whitebreak, so Whitebreakian citizens enjoy more decorations for their homes. In this case, the terms of the increase in trade correspond to the improvement of the Whitebreak. Note that the Falterans are also better even though their terms of trade have fallen because they increase the consumption of the goods they want.
But suppose, instead of an increase in demand for Whitebreakian wheat, there is an accident that wipes out the harvest. This decrease in supply can cause the price of wheat to increase. Again, this increase in the price of wheat would improve Whitebreak’s trading terms with Faltera, but this time Whitebreak’s people make it worse: they have less wheat to eat (and, therefore, less wheat to trade for art). Their economic life is deteriorating. In this case, the goals of trade development do not a sign of the improvement in the living standards of Whitebreakians.
In real life, both the price of exports and the price of imports are constantly changing. Since trade terms are average, they can also change depending on percentage changes in prices. For example, suppose there is a recession and the prices of both Whitebreak wheat and Faltera wheat fall due to reduced demand. Art is a beautiful thing, so the decline will be much greater in the work of art than in wheat. If, say, wheat prices fall by 3% but art prices fall by 20%, the terms of trade will improve. Also, this development is misleading about the well-being of Whitebreakians and Falterans.
Understanding this limitation in terms of trade, or any equation, is important for discussing trade policy. Judging the success or failure of a policy by a single metric (or even a basket) can lead to incorrect assumptions if one does not understand the underlying data influencing the metric.
None of this means we need to abandon trade terms. Useful statistics. But like any statistic, we must be careful in its use and interpretation. Ultimately, the answer to whether the terms of trade promotion (or recession) is a good or bad thing is: “it depends.”
Jon Murphy is an assistant professor of economics at Nicholls State University.
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