Terms of Trade

admin — Thu, 25 Jun 2009 21:35:01 +0000

Another important aspect of the external balance approach to exchange rate determination is the so-called “terms of trade”, which is the relationship between a country’s export and import prices. A country’s terms of trade can be an important determinant of its long-term equilibrium real exchange rate. We ﬁnd this particularly the case for countries that are major commodity exporters and therefore whose economies are particularly sensitive to swings in commodity prices. An improvement in a country’s terms of trade, that is a rise in its export prices relative to import prices, should lead to a rise in the real exchange rate equilibrium value. Rising export prices should be reﬂective of rising global demand for that country’s exports, both on an absolute basis and relative to domestic demand levels. Consequently, one should assume that an improvement in the terms of trade should lead to an improvement in the current account balance, which in turn requires a real exchange rate appreciation to restore equilibrium. Equally, a deterioration in the terms of trade leads to a current account deterioration, which requires a real exchange rate depreciation to restore equilibrium. For the sake of clarity, we can express this transmission mechanism using the following simple diagram:
Change in terms of trade -> Change in current account balance -> Real exchange rate change to restore equilibrium
Taking oil as an example, the terms of trade concept is an important determinant of the long term real exchange rate equilibrium value for the countries of the Gulf, Mexico, Venezuela, Colombia, Nigeria, Indonesia, Russia, the UK and Norway. Note that these are just the exporters. The terms of trade concept also works for the importers as well, which is why when the international price of oil experiences a signiﬁcant uptrend, this causes a terms of trade deterioration for the major oil importers, leading to current account balance deterioration. All else being equal, this should require a real exchange rate depreciation to restore equilibrium.

Financial issues » Trade

Terms of Trade