The recent history of New Zealand’s terms of trade has been largely linked to dairy product export prices although in a longer-term context the price of imported oil has been paramount. Today we can see that the price of powdered milk (export) and the price of brent crude oil (import) are heading in the wrong directions. Powdered milk prices are falling and brent crude oil prices are rising which makes for an unfavourable terms of trade – see graph. This is not a good sign for the terms of trade which reached its peak in March this year.
What is the Terms of Trade.
The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another. The formula is:
Formula: Terms of Trade (TOT) =
Export Price Index (Px) x 1000 (base year)
Import Price Index (Pm)
- An increase in the TOT (e.g. from 1050 to 1200) is called “favourable”
- A decrease in the TOT (e.g. from 1050 to 970) is called “unfavourable”
A “favourable” (increase) in the TOT may come about because the average:
– export price rose and import price stayed the same
– export prices rose faster than import prices
– export prices stayed the same and import prices fell
– export prices fell but import prices fell faster
The index number that results tells us whether merchandise export price movements have been favourable relative to import price movements. An increase in the terms of trade from 1000 to 1100 represents an increase in the purchasing power of our exports of 10% which means, other things being equal, we would be able to buy 10% more from overseas. As a country we would be wealthier. A decline in the terms of trade would result in the opposite situation.
Limitations of the Terms of Trade
Terms of trade calculations do not tell us about the volume of the countries’ exports, only relative changes between countries. To understand how a country’s social utility changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.
The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price. An example of this is the high export price suffered by New Zealand exporters since mid-2000 as a result of the historical mandate given to the Reserve Bank of New Zealand to control inflation.
In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.
- A decline in the terms of trade is not necessarily a bad thing. For example, a decline in the terms of trade may occur due to a devaluation in the exchange rate. This devaluation may enable a country to regain competitiveness and increase the quantity of exports.
- The impact of a decline in the terms of trade will depend on the elasticity of demand. If demand is elastic, the lower price of exports will cause a bigger % increase in demand.
- Some Less Developed Countries (LDCs) have seen an improvement in terms of trade because of rising price of commodities and food post 2008. It is not always LDCs who see a decline in the terms of trade.
- It is important to distinguish between a short term decline in terms of trade and a long term decline. A long term decline is more serious for reflecting a fall in living standards.