November 2013

Explaining the ToT The ToT is the ratio of the average price of exports to the average price of imports: It is a measure of the amount of imports that can be exchanged per unit of exports.

Assume that Finland and Russia trade only mobile phones (Finland) and caviar (Russia): One mob phone = USD 300 One hectogram caviar = USD 100 ToT Finland = 300/100 = 3 → One phone buys 3 hectograms caviar ToT Russia = 100/300 = 0.33 → One hect caviar will buy 0.33 mob phones.

Suppose price of caviar ↑ to USD 200: ToT Fin = 300/200 = 1.5 (↓) Deterioration of ToT ToT Rus = 200/300 = 0.66 (↑) Improvement of ToT Improvement in the ToT: an increase in the value of the ratio of average price of X to average price of M. It is a fall in the opportunity cost of imports. Deterioration in the ToT: a decrease in the value of the ratio of average X prices to average M prices. It is an increase in the opportunity cost of imports.

↑Price M or ↓Price X → Deterioration ToT ↓Price M or ↑Price X → Improvement ToT We cannot always conclude Improvement (Deterioration) of ToT makes a country to be better (worse) off. This depends on the causes of changes in the ToT.

Changes in the short-run 1. Changes in global demand due to: Changes in consumer tastes Changing needs of producers (demand for cereals) 2. Changes in global supply due to: Restrictions in the availability of an input (oil) Weather conditions 3. Changes in exchange rates: depreciation deteriorates the ToT, apreciation improves ToT. 4. Changes in domestic rate of inflation

Changes in the long term 1. Growth in incomes, affecting global demand: Given low YED for food, prices of primary products rise less rapidly than prices of manufactured goods and of services: deterioration of ToT for countries that export primary products and import manufactured products. 2. Changes in productivity: →Lower costs of production → shift S curve to right → ↓p 3. Technological advances (telecommunications, transport, agriculture,…). Same effect as productivity. 4. Trade protection

4. Trade protection: Through trade protection, the US could decrease the global demand for cars and lower the price for car exporters. Agricultural subsidies granted by the US and the EU have the effect of increasing global supply and decreasing world prices.

Effects on the current account Balance of Trade = Value of X – Value of M Balance of Trade = X revenues – M expenditures = p X X – p M M A change in the ToT leads to an improvement in the balance of trade (smaller deficit or larger surplus) if it causes an increase in the value of X or a decrease in the value of M.

1.Changes in global demand Increase: both p and q increase Importer: ToT deteriorate and M expenditures increase, so Balance of Trade worsens Exporter: ToT improve and BoT improve Decrease: both p and q fall Importer ….. Exporter…. ToT and B of Trade move in the same direction!

2.Changes in global supply Change in S → p and q move in opposite directions: Increase in Supply: p↓ and q↑ Decrease in Supply: p ↑ and q ↓ Effect on import expenditures and export revenues will depend on the PED for exports and imports.

If there is an increase in global supply: Exporters: ToT deteriorate. Improve or worsen CA? If PEDX<1 → X revenues decrease → BoT worsens If PEDX>1 → X revenues increase → BoT improves Importers: ToT improve. Improve or worsen CA? If PEDX<1 → M expend decrease→ BoT improves If PEDX>1 → M expend increase → BoT worsens If PED <1 ToT and BoT change in same direction

3.Changes in exchange rates 1. Depreciation → Pm ↑ → deterioration ToT If Marshall-Lerner condition holds the trade balance will improve. 2. Appreciation → Pm ↓ → improvement ToT If Marshall-Lerner condition does not hold the trade balance will worsen.