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Section 3: International Trade
International Trade
International trade refers to the exchange of goods and services through imports and exports
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Exports: Goods and services sold to other countries
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Trade deficit: Imports exceed export
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Economies of scale in production
Greater choice for consumers
Increased competition and greater efficiency in production
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Source of foreign exchange
Flow of new ideas and technology
Trade as an ‘engine of growth
Absolute Advantage and Comparative Advantage
Absolute advantage: producing a specific good with fewer resources (more efficiently) than
another country
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* Free trade (international trade that occurs without restrictions/barriers, due to the absence of
government intervention) forms a basic assumption of the theories of comparative advantage
and absolute advantage
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Provides a forum for trade negotiations
Provides a forum for members to discuss their trade problems and negotiate trade agreements
on how to liberalize trade
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Members are required to notify the WTO of any changes in trade policy
Provides technical assistance and training for developing countries
Facilitates co-operation with other international organizations
Co-operates with international organizations (world bank) to facilitate coordination of global
policies
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Quota: A limit on imports
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Embargo: A complete ban on trade
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Health and safety standards
Environmental standards
Subsidies
Protectionism is bad because
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Lack of competition → less efficiency for
producers
Higher price paid by consumers because
protected goods are expensive
Less choice for consumers
Income distribution worsens with trade
protection
Foreign producers are worse off
Trade wars
Negative effects on export competitiveness
Protects infant industries by limiting
competition
National security
Health, safety and environmental standards
Tariffs as a source of government revenue
Encourages anti-dumping: (dumping=selling
a good in international markets at a price
that’s below cost of production → unfair
practice)
Protection of domestic employment
Wage protection (prevent importing from
countries that produce and lower costs
because of cheap labor)
Free trade diagram
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Tariff Diagram
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Increase in quantity supplied, decrease in quantity demand, decrease in imports
Domestic consumers are worse off because higher price
Domestic producers are better off because increase in revenue
Domestic employment increases
Government gains tariff revenues
Domestic income distribution worsens
Increased inefficiency in production
Foreign producers are worse off
Subsidy Diagram
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Increase in quantity supplied, decrease in imports
Consumption of the good is not affected (demand is the same)
Domestic producers are better off
Negative effect of the government budget
Taxpayers are worse off
Domestic employment increases
Increased efficiency in production
The exporting countries are worse off
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Quota Diagram
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Increase in quantity supplied, decrease in quantity demand, decrease in imports
Domestic consumers are worse off
Domestic producers are better off
Domestic employment increases
The government neither gains nor loses
Domestic income distribution worsens
Increased inefficiency in production
Exchange rates
Determination of freely floating exchange rates
Exchange rates are determined by forces of demand and supply
Example of US and the EU
○ If the price of dollars in terms of euros increases, euro zone residents would demand
fewer dollars
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80 euro is needed to buy 1 dollar, euro zone residents buy fewer dollars
than if 0
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○ As the price of the dollar increases, euro zone goods become cheaper, and so the
quantity of dollars supplied increases
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8 euros to buy 1 dollar instead of 0
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→ US residents can purchase
goods from the EU more cheaply
○ If the exchange rate were higher (0
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5 euro per dollar) → excess demand for dollars
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Causes of changes in the exchange rate
Foreign demand for a country’s exports
If there is an increase in foreigners’ demand for a foreign good, the demand for that foreign
currency increases because more people would want to exchange their currency for that foreign
currency to purchase the foreign good
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Imports from foreign countries with lower inflation rates: increase because it is cheaper
There will be an increase in supply of the domestic currency (more domestic importers are
willing to supply their currency to the foreign exchange market to purchase imports)
Overall, higher rate of inflation in a country relative to other countries → currency depreciation
due to decreased demand and increased supply for the domestic currency
Investment from abroad
To invest in a foreign country, must buy that country’s currency → demand for that currency
increases → that currency appreciates → vice versa
Changes in income
If income levels increase in a country, consumers of that country would demand more imports
for foreign countries → increases supply of the domestic currency in the foreign exchange
market → currency of that country depreciates → vice versa
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Speculation
Buying or selling currencies to make a profit from changes in exchange rates
If speculators think a country’s currency is going to appreciate in the future, they would buy it
hoping to make a profit when they sell it later during the appreciation (vice versa)
Use of foreign currency reserve
Every central bank hold reserves for foreign currencies that they buy or sell to influence the
value of the domestic currency
If they buy more of a foreign currency and sell domestic currency, the domestic currency would
depreciate and vice versa
Currency Appreciation and Depreciation
Appreciation: A rise in the value of a currency in a floating exchange system
○ Currency appreciates: a unit of it can buy more of other currencies → imports
become cheaper
○ Exports become more expensive: foreigners have to pay higher amounts to
purchase the appreciated currency
Depreciation: A fall in the value of a currency in a floating exchange system
○ Currency depreciates: a unit of it can buy less of other currencies→ imports become
more expensive
○ Exports become cheaper: foreigners would have to pay lower amounts to purchase
the depreciated currency
Effects of exchange rate changes
Effects on the rate of inflation
Cost-push inflation
Depreciation causes imports to become more expensive → increases the cost of production for
domestic producers that rely on imports as a FOP
The more inelastic the demand for imports, the greater the cost push inflation
On the other hand, appreciation will cause the opposite of what was mentioned above, and will
lessen the inflationary pressure
Demand pull inflation
Depreciation will cause net exports to increase → aggregate demand increases → inflationary
pressure will arise if the country is producing or close to potential output
Appreciation will reduce demand-pull inflationary pressures by decreasing net exports
Effects on employment
Depreciation may cause a fall in cyclical unemployment as net exports rises, and therefore
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aggregate demand
Appreciation may lead to cyclical unemployment as exports fall and therefore aggregate
demand
Effects on economic growth
Depreciation → increase in net exports → increase in AD → increase in RGDP produced →
increase in economic growth → possible inflation
Appreciation → decrease in net exports → decrease in AD → decrease in RGDP produced →
fall in economic growth only to an extent because appreciation causes imports to become
cheaper, and therefore there would be an increase in FOP that can increase private or
government spending
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5 Mnl=$1, Mountainland owed
the US $1000, which meant it had to pay the US 1500 Mnl
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It shows:
Credits: payments received from other countries
Debits: all payments made to other countries
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Current Account
The current account is made up of the following payments:
Trade in goods: the import and export of finished goods(cars, computers); semi-finished
goods(parts/components for assembly), commodities (oil, tea, coffee)
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Net investment income:
Inflow/outflow of wages, rents, interest and profits
Remittances
Foreign aid
Transfers: Transfers in items such as gifts, donations to charity and overseas aid
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The capital account is relatively small compared to the current
account and financial account
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*Balance of financial account = sum of all items above
“Balance” in balance of payments
Errors and omissions: it is difficult to record every single transaction between countries (some
are unrecorded)
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If the sum of credits is larger than the sum of debits, this includes a debit item to create the
equality
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As seen above, there is a deficit in the current account of -20
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A current account balance is matched by the sum of the financial account balance (plus errors
and omissions)
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A current account surplus is matched by a deficit in the financial account
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Balance of payments surplus: There is a surplus in the combined current account, financial
accounts (plus errors and omissions) excluding central bank intervention
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At the initial equilibrium rate 0
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The US has a surplus on its current account, and since nothing has changed in remaining
accounts, it has excess credits in its balance of payments → imbalance of payments
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At the initial equilibrium exchange rate 1
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The euro zone counties have a greater current account deficit
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When there is a deficit in the current account, market forces create a downward pressure on the
currency exchange rate
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* As a result, exchange rates automatically eliminate current account deficits and surpluses and
create a balance in payments
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It will appear more competitive → there will be a rise in the quantity of exports
Assuming demand for exports is relatively elastic
Will lead to an increase in the value of exports → improve the current account deficit
Lead to an increase in the cost of buying imports
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*Depreciation in the exchange rate should improve the current account and an appreciation
should worsen the current account
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Most common intervention: buying and selling of reserve currencies
Thailand has a deficit in its balance of payments of 1 million, meaning there are excess debits
due to an excess supply of the baht (in free floating system, without intervention, the baht would
have depreciated)
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A balance of payment is made by a combination of central banks buying and selling of currency
and market forces
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● At some point, Thai bank will run out of dollars to sell
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◆ To increase credits in the financial account:
○ The central bank can increase interest rates, thus attracting foreign financial investments
○ The government can borrow from abroad
◆ To decrease debits
● Government can limit imports (contractionary fiscal and monetary, trade protection)
● Impose exchange controls
In a fixed exchange rate system, the balance of payments is made to balance by policies that
keep the exchange rate fixed
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The balance of payments balances
entirely through market forces
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A current account deficit is eliminated
through currency depreciation
A surplus is eliminated by currency
appreciation
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If there is
a current account deficit, reserve currencies
can be sold to buy domestic currency →
creates credits in financial account to offset
the excess debit in the current account
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No easy methods to correct imbalances
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➔ Large or persistent current account deficits
require large quantities of foreign currency
reserves or access to foreign borrowing
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A fall in oil prices leading to a current account
deficit is met by a fall in the value of the
currency
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Flexibility
offered to
policy
makers
Great flexibility
Domestic economic policy does not need to
respond to balance problems → they can
focus on other domestic issues
eg
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➔ Borrowing from abroad also increases inflows
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expansionary fiscal/monetary and the current
account deficit will be corrected through
currency depreciation
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Implications of a persistent current account deficit
*Current account deficits are mainly because of an excess of imports over exports over a long
period of time
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However the hike in
interest rates discourage domestic investment
and consumption spending → recession
Borrowed funds are used to finance imports
of capital goods and other inputs need in
production (instead of consumer goods
imports)
If a country borrows for a long period of time,
its debt level maybe too high that it wouldn’t
be able to pay it back
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Some production is geared towards export
industries so that exports increase, making
increased export earnings possible (to help
pay back loans and interest, and finance
more capital goods imports)
Current account deficit puts downward
pressure on exchange rate
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The downward pressure on the currency can
get much stronger because people would not
want to hold currencies whose value is
expected to fall in the future, therefore they
sell it off
If loans accumulate over a long period of time,
there may be lower economic growth because
resources are used up on interest payments
and loan repayments
Methods to correct a persistent current account deficit
Expenditure-reducing policies (reductions in aggregate demand): Policy aimed to influence
the levels of imports and exports by reducing domestic expenditures through lower aggregate
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demand
Uses contractionary fiscal and monetary policies to reduce aggregate demand and therefore
output and incomes → lower demand for imports and lower rate of inflation, which may make
domestic goods more competitive and increase exports
Expenditure-switching policies: Policy intended to shift consumption away from imported
goods and towards domestically produced goods
Trade protection
Advantage: Increases barriers to trade to restrict imports, which can mitigate current account
deficits
Disadvantage:
Higher domestic prices of protected goods
Lower domestic consumption
Inefficiency and domestic and global misallocation of resources
Depreciation
Advantage: The government allows the country’s currency value to depreciate as they anticipate
that the rise in import prices would encourage domestica consumers to purchase more
domestically produced goods
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This is
an opportunity for them to expand export industries, expand the economy and increase
employment
Disadvantage:
Creates an unfair competitive advantage to other countries
Supply side policies to increase competitiveness
Advantage:
Lower costs of production for firms by increasing competition → lower prices (lower inflation)
Over a long period of time, lower rates of inflation may increase exports, thereby addressing the
current account deficit
Disadvantage:
Lag time
The Marshall-Lerner condition and the J curve effect
Marshall-Lerner
The marshall lerner condition is one that allows devaluation or depreciation to lead to an
improvement in a country’s balance of trade
The marshall lerner condition states:
If the sum of the PEDs for imports and exports is greater than 1, devaluation or depreciation will
improve the trade balance (will make a trade deficit smaller)
If the sum of the two PEDs is less than 1, devaluation/depreciation will worsen the trade balance
(will make trade deficit larger)
If the sum of the two PEDs is equal to 1, devaluation/depreciation will leave the trade balance
unchanged
J-curve effect, with reference to the marshall-lerner condition
Devaluing/Depreciating country may experience a worsening trade balance immediately
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following devaluation or depreciation of its currency
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This is known as the J-curve effect
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The aim of economic
integration is to reduce costs for both consumers and producers, as well as to increase trade
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Benefits of economic integration:
Increased competition
The removal of trade barriers → increased competition among producers in member countries
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Increased competition offers advantages
Efficient producers
Lower prices for consumers
The benefit of being able to sell to beyond national boundaries → increases exports and
leads to greater economic growth (expansion to larger markets)
Economies of scale
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As the size of the market expands, the firm can achieve:
Lower average costs of production (economies of scale)
Lower prices for consumers
Greater export competitiveness
Preferential trade agreements
A preferential trade agreement (a type of trading bloc) is an agreement between two or more
countries to lower trade barriers between each other on particular products
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take form in: free trade areas, customs unions, common markets, reducing/eliminating tariffs
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These agreements can be bilateral or multilateral
Bilateral agreement: an agreement between two countries
Multilateral: an agreement between multiple countries
Trading blocs
A group of countries that have agreed to reduce tariff and other barriers to trade for the purpose
of encouraging free(er) trade amongst each other
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Each country does not have the right to determine its own trade policy for non-members
Members act as a group in all trade negotiations and agreements with non-members
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Continues to have a common external policy
They agree to eliminate all restrictions on movements of any factors of production within the
common market
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Benefits of free trade
● Lower prices for consumers, greater consumer choice
● Increased investment
○ Enlarged markets often give firms an incentive to invest in them due to the advantage of the
larger market size (they escape the tariff or other protection methods)
● Better use of factors of production (improved resource allocation)
● If trading blocs form a common market, unemployed workers in one country can seek jobs in
other member countries (greater opportunities)
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Drawbacks of free trade
Trading blocs may not be the best way to achieve trade liberalization
Trading blocs involve an increasing amount of discrimination, violating WTO’s nondiscrimination principle
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Blocs may have advantages within their group, but barriers on non-members may limit trade on
a global scale
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Trade creation: higher cost products are replaced by lower cost imports after the formation of a
trading bloc
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US and Canada produce cotton
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Initially
Canada imposes tariffs on cotton imports, allowing protection of domestic cotton
producers
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Canada’s cotton imports increase, domestic production decreases
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Trade diversion: lower cost imports are replaced by higher cost imports from a member after
the formation of a trading bloc
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Canada, US, UK all produce cotton
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Canada imposes a tariff on all cotton import
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Canada then decides to cotton tariff with UK, but
keeps tariff for US
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Canada's imports have now shifted from a lower cost
producer (US) to a higher one (UK)
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Monetary union
Occurs when members of a common market adopt a common currency and a central bank
responsible for monetary policy
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(same pros as fixed exchange rate degree of
certainty)
eliminates transaction costs
Eliminates the cost converting one currency to another, resulting in significant savings that
encourage trade investments and international financial flows of all kinds
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Disadvantages
Involves loss of exchange rates as a mechanism for adjustment
If a member country has a trade deficit, it no longer has its own national currency that could
depreciate (flexible exchange rate) or devalue (fixed exchange rate) to correct the imbalance
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Fiscal policy is constrained by the convergence requirements
There are restrictions imposed by the convergence requirements when carrying out fiscal
policies
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Exporters experience a terms of trade improvement
Importers experience a terms of trade deterioration
Changes in global supply
If the global supply of a certain good increases, its price would also increase
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Changes in the domestic rate of inflation relative to other countries
Higher rate of domestic inflation means the country’s export prices increase relative to its import
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prices, resulting in an improvement in terms of trade
There is a terms of trade deterioration for the country that imports goods from the domestic
country
Changes in exchange rates
Exchange rates affect prices of both exports and imports, and therefore impact terms of trade
If a currency depreciates, prices of imports increase in terms of the domestic currency, and the
country would experience a deterioration in the terms of trade
In the case of appreciation, import prices fall, while export prices remain the same, so a country
would experience an improvement in the terms of trade
In the long term:
Growth in incomes affecting global demand
As income increases, the demand for goods and services increases
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The responsiveness of demand to changes in the price of food and other primary products are
low
The responsiveness of demand to changes in the price of manufactured products and services
are higher
As incomes increase, the prices of food and other primary products rise less rapidly than the
prices of manufactured goods and services
Therefore, countries that export manufactured goods or that import primary products have been
experiencing improving terms of trade, while countries that export primary products and import
manufactured goods experience deteriorating terms of trade
Changes in productivity
If productivity increases occur in industries producing goods for export, the terms of trade will
deteriorate as export prices fall relative to import prices
Technological advances
Tech advances increase productivity, and the effect is like previously mentioned
Trade protection
A country can use trade protection to restrict imports to lower demand for exports
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Consequences of changes in the terms of trade
Changes in the terms of trade in the long term may result in global redistribution of
income
Changes in terms of trade can result in global redistribution of income because a country can
purchase a larger quantity of imports with the same quantity of exports
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These countries suffer a transfer of output away
from the domestic economy because they are forced to export more to maintain a certain
quantity of imports
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For example, if mountainland is a wheat importer and the demand for wheat increases causing
a higher wheat price, there will be a deterioration in the terms of trade for mountainland because
imports would be more expensive than exports
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Improvement in the terms of trade causes deterioration in the trade balance
Deterioration in the terms of trade causes an improvement in the trade balance
Changes in inflation rate
In a flexible exchange rate system, a change in the rate of inflation is likely to lead to changes in
the exchange rate, which has its own effect on terms of trade and trade balance
Increase in inflation may prompt government and central bank intervention to implement policies
that may have their own effects on the terms of trade and trade balance
Changes in exchange rate
Appreciation leads to worsening trade balance
Depreciation leads to improvement in trade balance
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