Inferences from price fluctuations: Trade

An important statistic in international trade economics is the “terms of trade.” The terms of trade are the ratio of export prices to import prices. In other words, the terms of trade are the relative prices that tell us how much of an import a country can buy with each dollar of exports. When export prices rise relative to import prices, a country’s terms of trade improve (expand). That is, people can buy more imports from abroad while giving up fewer exports. Conversely, when import prices rise relative to export prices, a country’s terms of trade fall (shrink). That is, people have to pay more of their exports to import the same value of imports.

For example, say there are two countries, Whitebreak and Fartera. Whitebreak exports wheat and imports art (and vice versa for Fartera). Wheat sells for $1 and art sells for $1. Initially, the terms of trade are 1. Now suppose the price of wheat doubles to $2. Whitebreak’s terms of trade improve to 2 ($2 wheat / $1 art). It can now buy 2 art pieces by selling the same amount of wheat. Whitebreak’s terms of trade have improved. Conversely, Fartera must give up 2 art pieces to buy the same amount of wheat.

Whitebrook’s terms of trade improved, but residents Is Whitebrake richer? You might be tempted to say “Yes! You can buy more with the same amount of resources, of course you will be richer!” As readers of this article’s title have probably already guessed, the answer is wrong. why Changes in prices can tell us more about whether people in Whitebrook are better off. Scott Sumner would sayDon’t judge by the price change.

There are two reasons why product prices fluctuate. request For the good and the change supply. As demand increases and the price of wheat rises, the people of Whitebreak become richer; that is, more wheat is consumed in the world, and more economic surplus is generated in the wheat market. Furthermore, since the Fartarians buy more, they sell more art to Whitebreak, and the inhabitants of Whitebreak have more ornaments to enjoy. In this case, the increase in the terms of trade correlates with the increase in wealth of Whitebreak. Note that the Fartarians are also richer because they increase their consumption of the goods they want, despite their terms of trade having fallen.

But suppose that, rather than an increase in Whitebrake’s demand for wheat, a blight outbreak destroys the crop. This reduction in supply causes the price of wheat to rise. And while the higher price of wheat improves the terms of trade between Whitebrake and Fartera, in this case the people of Whitebrake are certainly worse off: they have less wheat to consume (and therefore less wheat to exchange for artefacts). Their economic well-being worsens. In this case, the improvement in the terms of trade is do not have A remarkable improvement in the standard of living of the people of Whitebrook.

In the real world, export and import prices are constantly changing. Because the terms of trade are ratios, they can also change depending on the percentage change in prices. For example, recession Both wheat in Whitebrake and art in Falterra have fallen in price due to a decrease in demand. Because art is a luxury good, the price of art will fall more than that of wheat. If, for example, the price of wheat falls by 3% and the price of art falls by 20%, the terms of trade will improve. Again, this improvement is misleading regarding the well-being of the people of Whitebrake and Falterra.

Understanding this limitation of trade terms, or any statistic, is important when discussing trade policy. Judging the success or failure of a policy on a single metric (or metric) can lead to flawed inferences if you don’t understand the underlying data that influences that metric.

This is not to say that we should abandon the terms of trade; it is a useful statistic. But like any statistic, it should be used and interpreted with care. Ultimately, the answer to whether improving (or worsening) terms of trade is a good or bad thing is “it depends.”