Chapter 77: HL extension Consequences of a change in the terms of trade (3.5)

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1 Chapter 77: HL extension Consequences of a change in the terms of trade (3.5) HL extensions Terms of trade and redistribution effects Terms of trade, PED and the balance of payments Terms of trade, commodities and LDCs Consequences of changes in the terms of trade Explain how changes in the terms of trade in the long term may result in a global redistribution of income Examine the effects of changes in the terms of trade on a country s current account, using the concepts of price elasticity of demand for exports and imports Explain the impacts of short term fluctuations and long term deterioration in the terms of trade of economically less developed countries that specialize in primary commodities, using the concepts of price elasticity of demand and supply for primary products and income elasticity of demand Redistribution effects It is all too common to fall into the trap of regarding improvement in the terms of trade as generally beneficial. This is an erroneous conclusion since the terms of trade is simply a ratio between the price of exports and the price of imports and tells us nothing about the effects of a change in the ratio. The fact is that there are a number of outcomes of a change in the terms of trade in both the balance of payments and the macro environment in general. EFFECTS OF AN IMPROVEMENT IN THE TERMS OF TRADE Good: Perhaps the most obvious effect is that a country which has improved its terms of trade will be able to consume more imports and thus experience a general increase in living standards. Another effect of being able to get more for domestic goods is that external debt servicing (i.e. paying off loans and interest) will be easier. Firms will also be able to import cheaper raw materials and capital, which can enhance competitiveness. Improved terms of trade can also improve the current account in the balance of payments. If exports are relatively inelastic, an improvement in the terms of trade can increase export revenue and improve the current account, since the relative increase in price will be greater than the relative fall in the quantity of export goods sold. The same holds true if imports are demand inelastic; import spending would decrease. Bad: As you may have guessed, if exports are demand elastic then an improvement in the terms of trade will cause export revenue to fall just as import spending would rise if the demand for imports is relatively

2 elastic. Both would have a negative effect on the balance of payments. A decrease in export revenue and/or an increase in import spending could lower national income and adversely affect employment. EFFECTS OF A DETERIORATION OF THE TERMS OF TRADE Good: A decrease in the price of exports relative to the price of imports will lead to an improvement in current account if the price elasticity of demand for exports is elastic. If the demand for exports is also price elastic then export revenue will increase and also improve the current account balance. Increased demand for exports and/or decreased demand for imports will increase aggregate demand and perhaps increase job opportunities. Bad: Higher prices of foreign goods will not only lower consumption possibilities for households, but increase foreign debt burdens and make imported factors dearer. A deterioration of the terms of trade will have a negative effect on the current account if the demand for export goods is price inelastic, as total export revenues will fall. Inelastic demand for imports will also be negative for the current account, as total import spending will rise. Ugly: See terms of trade for developing countries further on. Terms of trade, PED and the balance of payments We have dealt with the issue of elasticities in conjunction with exports and imports in some depth already, more specifically in Chapter 73. Let me summarise with a few examples of how different price elasticities of demand for traded goods can affect the price, terms of trade and the balance of payments. PRICE ELASTICITY OF DEMAND AND PRICE FLUCTUATIONS As shown in Chapter 9 (Applied economics; commodity price fluctuations), primary good prices will fluctuate a great deal more than prices for secondary goods. Figure 77.1 PED price fluctuations for primary and secondary goods P ($) S 1 S 2 S 0 Price fluctuations of primary goods Price fluctuations of secondary goods D Imports of secondary goods D Imports of primary goods Q/t Figure 77.1 illustrates how changes in supply will cause different price fluctuations for primary and secondary goods. Demand for primary goods is more inelastic than demand for secondary goods, as primary goods have fewer substitutes. A disruption, shock, in supply such as a poor harvest/flooding (primary goods) or disruptions in the supply of factor inputs (secondary goods) shifts the supply curve from S 0 to S 2. A good season or improved technology shifts supply from S 0 to S 1. The outcome of decreased or

3 increased supply is of course fluctuations in price, but far more for primary goods than for secondary goods. PED, TERMS OF TRADE AND BALANCE OF PAYMENTS The commodity price index diagram further on (figure 77.3) shows that the price of primary goods has fallen fairly consistently during the past 100 years the exception being the past decade. Diagrams I and II in figure 77.2 illustrate how the terms of trade for commodity exporters have deteriorated over time; increased supply of both primary and secondary goods has lowered prices over time, but due to low price inelasticity of demand, the price of primary goods has fallen from 100 to 60 more than that of secondary goods which have fallen from 100 to 80. As the relative price of primary goods fallen more than that of secondary goods, primary good exporters have had a worsening in their terms of trade. Figure 77.2 PED and terms of trade I: Primary goods exporters P (index in constant USD) S 0 (exports) S 1 (exports) II: Secondary goods exporters P (index in constant USD) S 0 (exports) S 1 (exports) Q 0 Q 1 D primary goods export revenue > export revenue; current account Q/t P 1, secondary goods P 1, primary goods The price of primary goods falls relative to secondary good; the terms of trade for primary goods exporters has worsened Q 0 Q 1 D primary goods Q/t export revenue < export revenue; current account The price elasticity of demand mechanism illustrated for imports in diagrams I and II in figure 77.2 has further consequences for countries dependent on a narrow range of primary goods for export earnings, namely the negative impact on the balance of payments. Diagram I shows how an increase in the supply of primary goods exports lowers net export revenue (the revenue gain is less than the revenue loss) while the same increase in supply for secondary goods increases net export revenue. This will have a negative effect on the current account for primary goods exporters but a positive effect on the current account for secondary goods exports.

4 LOW YED AND FALLING PRIMARY GOODS PRICES Adding into the complex equation of PED, falling commodity prices and balance of payments issues is the issue of low income elasticity of demand (yed) for primary goods. Here is how low yed for primary goods causes falling prices for commodities in the long run: Low income elasticity of demand for primary goods in more developed nations (MDCs) means that even though MDC incomes increase, demand for primary goods increases proportionately less. This is shown in figure 77.3 as the increase in supply outstripping the increase in demand over the long term. Demand has also increased at a slower rate than supply since importers primarily MDCs have increasingly found ways to substitute many primary goods. Also, increased efficiency in use of raw materials together with recycling has helped lower the rate at which demand increases over time. Improvements in farming methods, new technology in extracting minerals, new methods of locating mineral sources etc, have all contributed to a remarkable increase in the supply of primary goods over the past 50 years. Figure 77.3 Long run supply and demand for commodities and yed 100 I: Primary goods exporters P (index in constant USD) 70 S 0 S 1 S 2 S LR As the increase in supply of primary goods (excluding oil) has been outstripping demand for some 50 years, the long run price trend has been decidedly downwards over the long term. LR trend, primary goods Q 0 D 0 D 1 Q LR D LR Q/t Terms of trade, commodities and LDCs Developing countries are frequently highly dependent on a few commodities (primary goods) for export earnings. In fact, 62 out of 141 developing countries depended on non-oil commodities for over 50% of all export earnings in 2000 and if oil is included, the number rises to Increasing supply and in many cases falling demand for commodities has resulted in continuously falling commodity prices over much of the past 50 years. Some commodity categories have in fact fallen by more than 50% in real terms and even the upswing in primary goods prices during the 2000s has not really had an impact on what figure 77.4 shows to be a long term downward trend in prices for commodities. Figure 77.4 Commodity prices over 50 years 1 UNDP, Commodity Dependence and International Commodity Prices 2010, pages 76 79

5 (Source: UNDP, Commodity Dependence and International Commodity Prices 2010, pages 76 79) Falling commodity prices have severely worsened the terms under which developing nations trade. Figure shows how the terms of trade (indexed at base year 2000) for developing nations which primarily export commodities have fallen since the 1970s. Figure 77.5 Terms of trade for commodity exporters (Source: IMF Working Paper WP/09/05, Commodity terms of trade: the history of booms and busts, September 2009)

6 So how dependent are developing countries on primary goods prices? No words necessary; just have a look at figure Have a good think on this. Figure 77.6 Correlation between commodity prices and growth in LDCs ( ) (Source: UNDP, Commodity Dependence and International Commodity Prices 2010, pages 76 79) (Source: UNDP, Commodity Dependence and International Commodity Prices 2010, pages 76 79) POP QUIZ 4.8.1: TERMS OF TRADE 1. How would a depreciation of the Canadian dollar affect USA and Mexico s terms of trade? 2. How might a deterioration of a country s terms of trade lead to inflation? 3. Why might an improvement of the terms of trade have negative effects for an economy? 4. How have deteriorating terms of trade affected the majority of less developed countries during the past 40 years.

SUMMARY OF TERMS OF TRADE AND LDCS Let us summarise a key point on deterioration of the terms of trade of developing countries in conjunction with the current account.

7 SUMMARY OF TERMS OF TRADE AND LDCS Let us summarise a key point on deterioration of the terms of trade of developing countries in conjunction with the current account. Falling commodity prices lead to a decrease in the terms of trade for LDCs. As the price elasticity of demand for commodities is low there is a decrease in export revenue and a worsening of the current account. In economic shorthand: supply for commodities has been outstripping demand for over 60 years price of commodities terms of trade (low PED for exports) export revenue current account and Y. The results of falling terms of trade for developing countries are almost always negative: Higher costs of debt servicing as a greater quantity of exports are necessary to earn a given amount of foreign currency with which to repay foreign debt. Current account deficits often lead to increased borrowing which in turn increases the debt burden. Falling commodity prices often encourage producers in developing countries to increase production of commodities which further depresses the world price of the commodity. Deteriorating terms of trade reduce much-needed imports such as capital, intermediate products in production, and fuel. All are needed to industrialise and increase value-added output. Less developed countries which have a comparative advantage in primary production will in all likelihood see their terms of trade decline even further in the near future due to increased capacity and low price elasticity of demand for primary goods. However Australia, one of the largest exporters of commodities in the world, has seen GDP growth of an average 5.3% annually in the latter half of the 2000s more than half of this growth came from commodity exports. Most of this is due to China s incredible appetite for raw materials. For example, between 2000 and 2010, Chinese imports (in USD terms) of iron increased by a factor of 42.5 and coal by a factor of 248! 2 Exports of minerals and agricultural goods made up 57% of Australia s exports in 2012 and exports made up 20% of Australian GDP which means that of export revenue came from primary goods. Figure 77.7 shows the effect on: The terms of trade: The terms of trade for Australia improved monumentally from 2000 onward by over 70% just before the economic crises hit in This was caused by high demand for Australian commodity exports and the exchange rate, which was export-led primarily. As the mining sector expanded to feed China s voracious appetite for raw materials, FDI poured in as foreign mining syndicates established in Australia. By 2010, 32% of all FDI inflows to Australia were in the mining sector. 3 This helps explain the current account deficit billions were coming in on the financial account! Current account: So, high growth, massive FDI and a strong exchange rate. This indicates a hefty current account deficit according to economic theory. I checked; Australia has something of a current account record in the OECD; the country has been running a current account deficit since So, while this makes the deficits during the 2000s somewhat less intimidating, one can still 2 and 3

7 Australian terms of trade, exchange rate and current account (1990 2009) (Rory, could you, em, fuse these two

8 see that rising terms of trade and a strengthened Australian dollar almost consistently worsened the current account during the 2002 to Figure 77.7 Australian terms of trade, exchange rate and current account ( ) (Rory, could you, em, fuse these two diags please. Start with 1990 and go to 2009.) (Sources: Reserve Bank of Australia at and )

9 PREPARING FOR EXAMS SHORT ANSWER QUESTIONS (10 MARKS EACH) 1. A current account deficit damages the domestic economy. Discuss. 2. Explain how a country which is experiencing a boom in the domestic economy might see the current account go into a deficit. 3. How might a country s exchange rate influence the balance of payments? 4. How might deteriorating terms of trade improve the current account in the balance of payments? 5. An appreciation of the exchange rate is always beneficial to an economy. Discuss. 6. Why might a devaluation of a country s currency not necessarily improve the current account in the short run? EXTENDED RESPONSE QUESTIONS (25 MARKS EACH) 1. (a) What problems might arise for a country running a current account deficit? (10 marks) (b) How might the deficit be reduced? (15 marks) 2. (a) Distinguish between the terms of trade and the balance of trade. (10 marks) (b) How might both be affected by a fall in the country s exchange rate? (15 marks) 3. (a) Explain how a country might have a consistent current account deficit for longer periods. (10 marks) (b) Is this necessarily a serious problem? (15 marks) Taken out of Ch a) Account for the difficulties of establishing a common currency amongst 10 countries. (10 marks) b) Discuss the costs and benefits of establishing a common currency. (15 marks)

10 Summary and revision 1. Improved terms of trade have positive re-distribution effects: a. Living standards improve as consumers can consumer more imports and have more choice b. External debt decreases in terms of export revenue c. Firms can import cheaper factors of production in terms of exports d. Better terms of trade can improve current account if exports and/or imports are price inelastic 2. Improved terms of trade can also come with disadvantages: a. Current account might worsen since exports are dearer and imports are cheaper 3. A deterioration of the terms of trade has possible benefits: a. As relative export prices have fallen, there might be an improvement in current account b. Increased exports might increase aggregate demand and thus income 4. Possible disadvantages of deterioration of the terms of trade: a. Higher import prices impact on consumers in terms of choice and living standards b. Export-driven economies might see the external debt burden increase c. For export goods that are price inelastic, a deterioration of the terms of trade might lead to a worsening of current account 5. Low PED, PES and yed for primary goods has disadvantaged primary goods exporting LDCs: a. Low PED and PED has led to extreme price volatility over many years b. Low yed for primary goods has often meant that demand from MDCs for primary goods has not increased in tune with growth c. Supply outstripping demand has lowered commodity prices in real terms over almost 50 years 6. Falling commodity prices has led to a deterioration of the terms of trade for developing nations over most of the past 50 years. Effects of this include: a. Current account deficits as export revenues fall b. Increased debt burdens since much of the debt is accrued from the foreign sector and export revenues are needed to service the debt c. Imports of much-needed capital goods become dearer in terms of export revenues

Economic Fundamentals in Australia MacGregor and Salla Sample responses to questions contained in Activity Centre: Unit 3 Outcome 3

Economic Fundamentals in Australia MacGregor and Salla Sample responses to questions contained in Activity Centre: Unit 3 Outcome 3 Question 1 a) Tariffs and quotas are both examples of means by which