IB Economics - International Economics


Terms in this set (...)

Involves the exchange of goods or services between two countries.
autarky (self-sufficiency)
the absence of trade
absolute advantage
Where a country is able to produce more output than other countries using the same input of factors of production.
-> Linked to the specialization of country to the production of one or a few goods & service.
comparative advantage
Where a country is able to produce a good at a lower opportunity cost of resources than another country.
An international body that sets the rules for global trading and resolves disputes between its member countries. It also hosts negotiations concerning the reduction of trade barriers between its member nations.
barriers to trade
A variety of methods used to restrict international trade flows, i.e. tariffs, quotas, subsidies, administrative barriers
A duty (tax) that is placed upon imports to protect domestic industries from foreign competition an/or to raise gov't revenue.
-> most common form of trade restriction
Import barriers that set limits on the quantity or value of imports that may be imported into a country.
-> usually does not yield gov't revenue
An amount of money paid by the government to a firm, per unit of output, to encourage output and to give the firm an advantage over foreign competition.
administrative barriers
additional obstacles imposed by a gov't to imports.
- quality standards (e.g. sanitary, pollution)
- safety standards (e.g. "Kinder chocolate eggs")
- complicated customs procedures (e.g. packaging requirements, red-tape checks)
The selling of a good in another country at a price below its unit cost of production.
arguments against and in favour of protectionism
negative effect on export competitiveness: if production inputs are more expensive, the final good is more expensive & higher price for exports :-(
trade protection may give rise to trade wars: retaliation after one country imposes protectionist measures :-(
creates a potential for corruption: parallel/informal market (black market) for protected goods, bureaucrats might receive tariff revenues :-(
infant industry argument: an industry just beginning (infant) has high costs, which require protection from low-cost imports until the industry can mature and can achieve low cost production. Since future allocation of resources could be better if infant industry is protected.
-> E.g. electric car industry in USA protected from German imports.
BUT difficulties selecting industries which need protection & protection might be prolonged. :-/
diversification of developing countries: protection restricts imports of goods that a country wants to produce itself to increase variety of goods it produces.
-> diversification reduces vulnerability to fluctuation in prices (opposite of specialization)
-> E.g Venezuela being dependent on oil for 96% of its exports
BUT can be abused if a country cannot produce good at low cost. :-/
National security: If there is a war, a country needs to be self sufficient in essential goods for defense
-> E.g. weapons, aircraft
BUT can be used as hidden protection (e.g. candle, gloves in the US) :-/
Health, safety, environmental standards:
e.g. "Kinder Surprise" chocolate eggs are deemed dangerous in USA so the imports of the goods are restricted.
BUT this reason may be abused to protect domestic industry. :-/
-> Dumping: occurs when imported goods are sold below cost of production. The WTO deems dumping illegal. So if a country is suspected of dumping, trade protection is justified.
BUT dumping is difficult to prove creating room for unjustified protection. :-/
Means to overcome balance of payments deficits: When more money is leaving a country than entering it trade protection can be used to counter this deficit.
BUT can lead to trade wars resulting in even less export revenue. :-/
Legislation to protect an economy against the importing of a good at a price below its unit cost of production.
retaliatory tariff
Where a country responds to the imposition of a tariff by a trading partner by imposing a tariff on that country's products.
infant industry argument
The argument that new industries should be protected from foreign competition until they are large enough to achieve economies of scale that will allow them to be competitive.
exchange rate
The value of one currency expressed in terms of another currency.
-> For example: on 7 April 2011 one needed 1.38 USD to purchase 1 EUR
• number of US dollars per euro: 1.38 USD
This means that one needed 0.73 EUR (the inverse of 1.38) to purchase 1 USD
• number of euros per dollar: 0.73 EUR
foreign exchange market
a market in which currencies are exchanged for other currencies (e.g. the exchange market in which dollars and euros are traded).
-> all buyers of a currency are at the same time sellers of their own currency
=> The demand for foreign currencies generates a supply of domestic currency; and demand for the domestic currency generates a supply of foreign currencies.
floating exchange rate system
An exchange rate regime where the value of a currency is allowed to be determined solely by the demand for, and supply of, the currency on the foreign exchange market.
An increase in the value of a country's currency in a floating exchange rate system.
-> If 'currency A' appreciates terms of 'currency B' it follows that 'currency B' depreciates in terms of 'currency A', as the one exchange rate is the inverse of the other.
A decrease in the value of a country's currency in a floating exchange rate system.
-> If 'currency A' depreciates in terms of 'currency B' it follows that 'currency B' appreciates in terms of 'currency A', as the one exchange rate is the inverse of the other.
Why is the demand curve for a currency downward-sloping?
The downward slope of the curve indicates that as the price of dollars in terms of euros increases, euro zone residents buy fewer dollars. For example, if 0.80 euro are needed to buy 1 dollar, euro zone residents
buy fewer dollars than if 0.5 euro is needed to buy 1 dollar. Therefore, as the price of dollars in terms
of euros increases, the quantity of dollars demanded decreases.
Why is the supply curve of a currency upward-sloping?
Consider that if the price of dollars is 0.5 euros per dollar, US residents need to supply 1 dollar to buy
0.5 euro worth of euro zone goods; if the price of dollars increases to 0.8 euro per dollar, then by giving up 1 dollar, US residents can buy 0.8 euro worth of euro zone goods. As the price of dollars goes up, euro zone goods become cheaper, and so more dollars are supplied. Therefore, as the price of dollars in terms
of euros increases, the quantity of dollars supplied increases.
Causes of changes in exchange rates (ceteris paribus)
Foreign demand for a country's exports: As demand for a country's exports increases, its currency appreciates.
Domestic demand for imports: As a country's imports increase, its currency depreciates.
Relative interest rate changes: A country's interest rates and the value of its currency change in the same direction.
Relative rates of inflation: Higher inflation in a country relative to other countries leads to currency depreciation.
Investment from abroad: An increase in foreign investment from abroad (of any type) results in currency appreciation.
Relative changes in income: A country's level of income relative to other countries and the value of its currency change in opposite directions.
Speculation: A widespread expectation that a currency will appreciate leads to currency buying that contributes to bringing about the appreciation. Expectation that a currency will depreciate leads to selling that contributes to bringing about the depreciation.
currency speculation
buying and selling currencies in order to make a profit from future movements in exchange rates.
Example for the effect of foreign demand for a country's exports
If there is an increase in foreigners' demand for Swiss watches, the demand for Swiss francs increases (demand-for-francs curve shifts to the right) => franc appreciates. A decrease in the foreign demand for a country's exports causes its currency to depreciate.
Example for the effect of domestic demand for imports
If consumers in the US import more foreign-made cars, US importers must buy foreign currencies, and to do so they supply US dollars in the foreign exchange market. The supply of dollars increases (supply-of-dollar curve shifts to the right) => dollar depreciates. If the US demand for foreign cars falls, there is a leftward shift in the supply-of-dollars curve, and the dollar appreciates.
Example for the effect of relative interest rate changes
The higher the rate of interest in a country, the more attractive the financial investments in that country. For example, if interest rates in the United Kingdom increase relative to interest rates in other countries, financial investments become more attractive in the United Kingdom, financial capital flows to the United Kingdom, demand for British pounds increases, the demand-for-pounds curve shifts to the right, and the pound appreciates.
Example for the effect of relative rates of inflation
If Sweden experiences a higher rate of inflation
than other countries, demand for its exports falls as other countries now find them too expensive; at the same time, imports from other countries with lower inflation rates increase as Swedes find them cheaper. => The fall in Swedish exports causes demand for Swedish currency (kronor) to decrease, while the increase in imports causes supply of Swedish kronor to increase.
=> leftward shift in demand & rightward shift in supply both causing the Swedish kronor to depreciate.
Example for the effect of relative changes in income
If income levels in India increase relative to other countries, Indian residents demand more imports from other countries, the supply of the Indian rupee increases as Indian residents exchange it for other currencies with which to buy the imports => rupee depreciates.
Evaluating effects of exchange rate changes
Changes in exchange rate affect inflation:
(a) Cost-push inflation: currency depreciation makes imports more expensive => cost of imported FoP increase => leftward shift of the SRAS curve & cost-push inflation.
(b) Demand-pull inflation: currency depreciation makes exports cheaper & imports more expensive => net exports (X − M) increase => rightward shift of the AD curve & demand-pul inflation.
Effects on employment: (i) if the economy is close to potential GDP, the increase in AD (due to higher net exports) may cause a temporary decrease in natural unemployment; (ii) if the economy is in a recessionary gap a rise in AD causes a fall in cyclical unemployment.
Effects on economic growth: in the case of a currency appreciation, economic growth results (due to the above consequences of growing net exports).
Currency appreciation (by directly reducing
net exports) is likely to damp economic growth. However, since a currency appreciation makes imports cheaper, there may result increased imports of FoP that can be used to increase private or government investment spending and therefore impact positively on potential output.
Effects on the current account balance: if a country has an excess of imports over exports to begin with (a trade 'deficit'), there will be downward pressure on the currency, leading to depreciation which will reduce the deficit. If it has an excess of exports over imports to begin with (a trade 'surplus'), its trade surplus become larger. An appreciation, by contrast, will cause net exports to fall, thus having the opposite effects on the current account balance.
fixed exchange rate system
An exchange rate regime where the value of a currency is set and maintained at a level, determined by a country's gov't (or its central bank).
-> As the prices of change rates are fixed upward & downward pressures on the value of the currency result:
- upward pressure: the currency 'wants' to appreciate but can't
- downward pressure: the currency 'wants' to depreciate but can't
pegged currency
A pegged currency combines fixed and managed exchange rates: Pegged currencies are fixed in relation to the dollar or euro, and float in relation to all other currencies.
-> Some developing and transition economies peg their currencies to the US dollar or euro.
-> pegging currencies stabilises the exchange rate of the pegged currency in relation to the currency to which it is pegged, preventing abrupt or strong fluctuations.
An increase in the value of a country's currency in a fixed exchange rate system.
A decrease in the value of a country's currency in a fixed exchange rate system.
Intervention to maintain fixed exchange rates
Using official reserves to maintain the exchange rate:
The central bank can buy foreign currency (USD) with domestic currency (EUR) which will have the effect lowering the exchange rate for EUR (as more EUR is supplied & more USD demanded),
-> So if there's too much upward pressure on the domestic currency (EUR), the central bank buys foreign currency reserves to devalue the EUR.
In case of a downward pressure on the EUR's exchange rate the central bank can revaluate the currency by selling of foreign currency reserves: This increases the supply (and demand) of EUR and raises its value.
N.B. the central bank can also raise interest rates to attract foreign investors, increasing demand for EUR.
foreign reserves
Foreign currencies held by governments (central banks) as a result of international trade. Reserves may be held so that the government may maintain a desired exchange rate for the country's currencies.
managed exchange rate system
Under the managed float, exchange rates are determined mainly through market forces, but with periodic intervention by central banks aiming to smooth out abrupt fluctuations. Intervention takes mainly the form of the buying and selling of official reserves.
balance of payments
The accounting record of all transactions (debits and credits) between the households, firms and government of one country, and the rest of the world.
-> The 'balance of payments' is divided into three major components: the current account, the capital, and the financial account. The sum of these always equals zero, as any debits must have been somehow balanced by credits.
current account
A measure of the international flow of funds from trade in goods and services (net exports), plus net investment income flows (profit, interest and dividends from portfolio and direct investment) and net current transfers of money (foreign aid, grants and remittances, i.e. unilateral transfers with nothing received in return).
-> If this balance is positive there is a current account surplus.
-> If this balance is negative there is a current account deficit .
=> A deficit on this account means there is an excess supply of the currency in the foreign exchange market.
portfolio investment
The purchase of financial investments such as shares and bonds in order to gain a financial return in the form of interest or dividends.
current account surplus
Where the revenue from the export of goods and services and income flows is greater than the expenditure on the import of goods and services and income flows in a given year.
current account deficit
Where revenue from the exports of goods and services and income flows is less than the expenditure on the import of goods and services and income flows in a given year.
capital account
A measure of inflows minus outflows of funds for capital transfers and transactions in non-produced, non-financial assets (debt forgiveness, patents, trademarks, franchises, leases). The capital account is relatively small compared to the current account and financial account.
=> a surplus on an account indicates there is an excess demand of the currency in the foreign exchange market.
financial account
A measure of the net change in foreign ownership of domestic financial assets, including foreign direct investment, portfolio investment (e.g. stocks and bonds) and changes in foreign reserves.
-> Inflows of funds due to borrowing from foreign lenders (foreign gov't debt) appear as credits under portfolio investment. Loans to foreign gov'ts lead to an outflow of funds appearing as debits under portfolio investment.
-> If a foreign firm decides to invest into the country by purchasing physical capital, the result is an inflow of funds, appearing as a credit in the financial account. If the owners of the corporation decide to take their profits out of that country and back to their home country, there is an outflow of funds, appearing as a debit in the current account.
-> If the country's central bank had sold its currency by buying dollars, this would be an outflow of its currency and would appear as a debit in the financial account.
'errors and omissions' in the balance of payments
If the sum of credits is larger than the sum of debits, then this includes a debit item to create the equality. If the sum of debits is larger, then the statistical discrepancy consists of a credit. This is simply a statistical 'trick'.
'balance' in the balance of payments
current account + (capital account + financial account + errors and omissions) = 0
current account = −(capital account + financial
account + errors and omissions)
=> A current account deficit means a country consumes more than it produces; and it pays for extra output consumed through a financial account surplus.
A current account surplus means a country consumes less than it produces, and part of the income generated from the sale of extra output corresponds to a financial account deficit.
=> If there is a deficit in the current account, the financial account is a reflection of the need to finance that deficit; if there is a surplus in the current account, it reflects investments in foreign countries undertaken to dispose of the extra foreign exchange.
foreign exchange
the foreign currencies acquired by a country which sells goods and services to other countries.
-> The acquired foreign currencies allow the country to make payments to other countries for the goods and services they import, or make other payments abroad.
'imbalance' in the balance of payments
a balance of payments deficit/surplus means there is a deficit/surplus in the combined current, capital and financial accounts (plus errors and omissions), excluding central bank intervention.
balancing deficits with surpluses under freely floating exchange rates
exchange rate changes automatically eliminate current account deficits and surpluses, and create a balance in the balance of payments:
- When there is a deficit in the current account, market forces create a downward pressure on the currency exchange rate.
- When there is a surplus in the current account, market forces create an upward pressure on the currency exchange rate.
balancing deficits with surpluses through government intervention in a managed exchange rate system (managed float)
In a managed exchange rate system, the balance of payments is made to balance by a combination of central bank buying and selling of currencies and market forces. This is necessary as deficit/surplus in the BoP is not balanced by an automatic appreciation/depreciation of the currency.
balancing deficits with surpluses through government intervention in a fixed exchange rate system
In a fixed exchange rate system, the balance of payments is made to balance by policies that keep the exchange rate fixed.
-> These measures are exactly the same as those needed to maintain the fixed exchange rate: increasing interest rates, borrowing from abroad to increase credits in the financial account & limiting imports (contractionary fiscal/monetary policies or trade protection), impose exchange controls to decrease debits.
comparing and contrasting exchange rate systems
Degree of certainty for stakeholders:
- Fixed exchange rates: high degree of certainty => easier for businesses to plan future investments; speculation is limited.
- Floating exchange rates: great uncertainty => negative effects on trade and investment flows due to inability to plan accurately & destabilising currency speculation
The role of foreign currency reserves:
- Fixed exchange rates: requires sufficient supplies of reserves of foreign currencies
- Floating exchange rates: not needed as balanced by market forces
Ease of adjustment:
- Fixed exchange rates: no easy methods to correct imbalances - external shocks (such as a sudden increase in oil prices leading to current account deficits for oil importers) can not be handled quickly
- Floating exchange rates: ability to adjust automatically to excess demand or supply of the domestic currency - a current account deficit is eliminated through currency depreciation; a surplus is eliminated by currency appreciation.
consequences of persistent current account deficits
If an economy is not earning enough foreign exchange from its exports & income earnings from abroad to afford its imports, a country may run into problems financing the balancing of the current account deficit.
-> Using foreign exchange reserves to balance out such a deficit is only possible over short periods.
-> Once these reserves have run out a country can still sell domestic assets (firms, stocks or property) to foreigners or borrow from abroad.
However, as the country is running a persistent current account deficit foreign buyer will only be willing to purchase at low prices.
=> This can result in the sale of significant assets such as natural resources or large industries at very low prices => threat of loss of sovereignty
Mounting foreign debt can jeopardize any future growth prospects of the economy, as future parts of national income are diverted from domestic uses toward debt repayment; further foreigners will be willing to lend only at higher and higher interest rates to compensate for the additional risks they face borrowing to a country with a risk of defaulting.
methods to correct persistent current account deficits
Expenditure-reducing policies:
+ use of expansionary fiscal/monetary policy leading to fewer imports and more exports can reduce the size of the current account deficit
- may create a recession in the domestic economy; risk that higher interest rates (contractionary monetary policy) leads to currency appreciation, which may discourage exports and encourage import
Expenditure-switching policies: intended to switch consumption away from imported goods and towards domestically produced goods.
(i) Trade protection: reduce the current account deficit by directly restricting imports BUT many negative consequences
(ii) Depreciation: a country with a persistent current account deficit is likely to face a strong downward pressure on its value and gov't may thus allow the currency to depreciate BUT higher prices for consumers could result as import prices rise.
Supply-side policies to increase competitiveness: over a long period of time, lower rates of inflation may increase exports, thereby addressing the current account deficit.
expenditure-reducing policies
Policies implemented by the government that attempt to reduce overall expenditure in the economy, in order to reduce expenditure on imports.
expenditure-switching policies
Policies implemented by the government that attempt to switch the expenditure of domestic consumers away from imports towards domestically produced goods and services.
export promotion
Strategies to encourage economic growth through increased international trade and the furtherance of export industries.
import substitution
Strategies to encourage the domestic production of goods in order to reduce imports and stimulate local producers. Such policies rely on the use of protectionism.
Marshall-Lerner condition
States that a depreciation, or devaluation, of a currency will only lead to an improvement in the current account balance if the PED for exports plus the PED for imports is greater than one.

The Marshall-Lerner condition states the following:
• If PEDm + PEDx > 1, devaluation/depreciation will improve the trade balance (will make a trade deficit smaller).
• If PEDm + PEDx < 1, devaluation/depreciation will worsen the trade balance (will make a trade deficit bigger).
• If PEDm + PEDx = 1, devaluation/depreciation will leave the trade balance unchanged.
Suggests that in the short term, a fall in the value of the currency will lead to a worsening of the current account deficit, before things improve in the long term.
-> The reason for this is that in the short-run when a currency (e.g. euro) has just depreciated, consumers in other countries (e.g. the USA) will not instantaneously be informed that euro-zone goods are now cheaper for them. Furthermore, some time is required until US consumers react to information & commercial contracts between exporting and importing goods may lead to time lags.
=> Initially the deficit becomes larger (Marshall-Lerner condition is unsatisfied as PED for exports and imports are both very low). Only after some time is the M.-L. condition satisfied and the trade deficit shrinks.
economic integration
refers to economic co-operation between countries and co-ordination of their economic policies, leading to increased economic links between them.
preferential trade agreement (PTA)
an agreement between two or more countries to lower trade barriers (e.g. reduced tariffs) between each other on particular products.
types of trade agreements
bilateral trade agreement: an agreement between two countries
multilateral trade agreement: an agreement between many countries.
regional trade agreements: agreement involving a group of countries that are within a geographical region.
=> The main objective of bilateral, regional and multilateral trade agreements is to promote trade liberalisation, which is free (or freer) trade by reducing or eliminating trade barriers between members.
countries cannot impose higher barriers on imports from one country and lower ones on imports from another country.
-> This is a fundamental principle for the development of free trade globally & one of the fundamental principles of the WTO
trade bloc
Any association of one or more countries where an agreement is made to reduce trade barriers (i.e. free trade area, customs union, common market).
-> Aim to encourage free or freer trade and co- operation
free trade area (FTA)
An agreement made between countries, where the countries agree to work towards free trade among themselves, but are able to trade with countries outside the free trade area in whatever way they wish.
-> Example: NAFTA (North American Free Trade Agreement)
customs union
An agreement made between countries, where the countries agree to work towards free trade among themselves and to adopt common external barriers against any country outside the union.
-> The member countries of a customs union act as a group in all trade negotiations and agreements with non-members. A customs union therefore involves a higher degree of economic integration than a free trade area.
-> Example: CEFTA (Central European Free Trade Agreement)
common market
A customs union with common policies on product regulation, and free movement of goods, services, capital and labour.
-> eliminates any remaining barriers to trade between the member nations => lower prices, greater consumer choice
-> better use of factors of production: e.g. there may be high unemployment in one country, and a high demand for labour in another country.
-> BUT requires willingness of member governments to give up some of their policy-making authority
-> Example: European Economic Community (EEC)
advantages of trading blocs
- Increased competition: removal of trade barriers results in increased competition among producers in member countries.
- Expansion into larger markets: as the size of the market expands, the firm can achieve lower costs of production on average (economies of scale), lower prices for consumers and greater export competitiveness.
- Lower prices for consumers and greater consumer choice
- Better use of factors of production: improved resource allocation
possible disadvantages of trading blocs
- May not be the best way to achieve trade liberalisation: trading blocs are inferior to the WTO's multilateral approach of reducing trade barriers towards all countries & involve an increasing amount of discrimination, violating the WTO's non-discrimination principle.
- trade diversion [see below]
trade creation (P3 X)
Occurs when the entry of a country into a trading bloc leads to the production of a good moving from a high-cost producer to a low-cost produce (=> greater allocative efficiency).
trade diversion (P3 X)
Occurs when the entry of a country into a trading bloc leads to the production of a good moving from a low-cost producer outside the union to a high-cost producer inside the union.
-> Trade diversion occurs when an importing country is forced to import from a higher cost producer within a trading bloc, whereas before it joined the trading bloc it was importing from a lower cost producer elsewhere.
monetary union
Where two or more countries share the same currency and have a common central bank (a far greater degree of integration than a common market).
-> Example: European Monetary Union (EMU)
advantages of monetary unions
- eliminates exchange rate risk and uncertainty.
- eliminates transaction costs.
- encourages price transparency: the ability of consumers and firms to compare prices in all the countries that have adopted a common currency without having to make exchange rate calculations and conversions.
disadvantages of monetary policy
- loss of exchange rates as a mechanism for adjustment: if a member country has a trade deficit with another member country, it no longer has its own national currency that could depreciate/devaluate
- loss of monetary policy as an instrument of economic policy: individual countries, whatever the particular circumstances (higher or lower inflation, unemployment, than the average of the euro zone countries), is unable to carry out its own monetary policy to influence the rate of interest and hence the level of economic activity.
- Fiscal policy is constrained by the convergence requirements: although member countries retain the ability to carry out their own fiscal policy, there are restrictions imposed by the convergence requirement (e.g. European Monetary Union: total public debt cannot be greater than 60% of GDP and the budget deficit of any given year cannot be greater than 3% of GDP). => This limits the government's ability to borrow according to domestic needs and priorities (e.g. pursuit of expansionary fiscal policy).
terms of trade (P3 X)
An index that shows the value of a country's average export prices relative to their average import prices.
-> Terms of trade = (index of average export prices/index of average import prices) × 100
=> When the numerator (export) increases ToT improve
improving ToT (P3 X)
Occurs when the average price of exports rises relatively to the price of imports => the country can attain a greater volume of imports with the same exports.
-> This is shown by an increase in the value of the ratio of average export prices to average import prices. It involves a fall in the opportunity cost of imports.
deteriorating ToT (P3 X)
Occurs when the average price of imports rises relatively to the price of exports => the country can attain a smaller volume of imports with the same exports.
-> This is shown by a decrease in the value of the ratio of average export prices to average import prices. It involves an increase in the opportunity cost of imports.
causes of changes in the terms of trade (P3 X)
Causes of changes in the short term
Changes in global demand: increases in global demand for a product cause its price to increase; decreases in global demand cause its price to fall (e.g. change in consumer tastes).
Changes in global supply: availability of important inputs in production (e.g. increase in the price of oil ToT+ for oil exporters & ToT- for oil importers).
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 prices => country's ToT+; at the same time ToT- of countries that import goods from the high inflation country.
Changes in exchange rates: if a country's currency appreciates ToT+; if a country's currency depreciates ToT-.
Causes of changes in the long term
Growth in incomes, affecting global demand: as incomes increase, the prices of food and other primary products rise less rapidly than the prices of manufactured goods/services (due to YED) => countries that export manufactured goods & import primary products have been experiencing improving ToT over many years, whereas countries that export mainly primary products & import manufactured products have been facing deteriorating ToT over long periods of time.
Changes in productivity: if productivity increases occur in industries producing goods for export, the ToT will likely deteriorate as export prices fall relative to import prices.
Trade protection: subsidies granted by large producers of a good may result in an increase in global supply and hence a fall in its price.
-> subsidies granted by the US and EU on their agricultural products have the effect of increasing global supply and depressing world prices => exporters of the same products (i.e. developing countries) therefore face deterioration in their ToT as the price of their export goods falls.
consequences of changes in the terms of trade (P3 X)
- Wealth is redistributed away from countries with deteriorating ToT and towards countries with improving ToT as the countries with deteriorating ToT have to all more exports just to be able to maintain the same level of imports => significant argument for diversification in developing countries!
- short-term fluctuations in the ToT of developing countries as agricultural goods are greatly affected by uncontrollable factors (e.g. weather) => producer & gov't uncertainty => planning difficulties, lower productivity & difficulties to make debt payments
- If a country's currency appreciates prices of exports increase in terms of the domestic currency => ToT+ (when PED<1) or ToT- (when PED>1); if a country's currency depreciates, prices of exports decrease in terms of the domestic currency => ToT- (when PED<1) or ToT+ (when PED>1).
- If a global supply of a good "A" increases, world price of the good falls => if PED good "A" is inelastic the current account decreases (less revenue) & => if PED of good "A" is elastic the current account increases (more revenue).
- When ToT change due to a change in the global demand for a good, the ToT and the balance of trade change in the same direction: either they both improve or they both deteriorate. This applies to both exporting and importing countries.