Demands of the question:

• Reasons/Causes and Effects (Consequences)
• Reasons for terms of trade changes – how increased oil price affects it
• Reasons for current account balance – how increased oil price affect it

Definition:

• Terms of Trade – An index that shows the value of a country’s average export prices relative to their average import.
• Capital Account -records the flows of money into and out of a country for investment and other purpose.There will be inflows of money (credits) and outflows of money from a country (debits).
• Current Account -records imports and exports of goods (sometimes known as the ‘balance of trade’ or ‘visible trade’) and imports and exports of services (sometimes known as ‘invisible trade’). It often also records income flows (flows of interest, profits and dividends that may have arisen from investment flows) and transfers of money
• Current Account Deficit - Exists where revenue from the exports of goods and services and income flowsa is less than the expenditure on the import of goods and services and income flows over a given time period.
• Current Account Surplus – Exists where 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 over a given period of time.
• Current Account Balance - net balance of all of these items – the net balance of trade in goods and the net balance of trade in services and net income flows.

Triple A:

The capital account breaks down into a number of sub-sections:

(i) Direct and portfolio investment – direct investment is productive investment. In other words it is investment in plant, equipment, machinery or factories – investment that will help with the process of wealth creation. Portfolio investment on the other hand is investment in paper assets like shares. There may be both inflows and outflows of portfolio investment.

(ii) Other financial flows – this heading can cover a range of short-term monetary flows like bank deposits from overseas residents, loans into a country from abroad and so on. These short-term flows often arise to take advantage of changes in interest rates between countries and are sometimes called ‘hot-money flows’. These flows are often of a purely speculative nature.

(iii) Flows to and from reserves – all countries hold reserves of foreign currency and this section measures any changes in these reserves. If the government were trying to influence the exchange rate, e.g. trying to create an appreciation in the rate, then they may sell some of their foreign currency reserves and buy their own currency instead.

Current account deficit

A current account deficit is generally thought to be undesirable (particularly in the long term) even if it is funded by a surplus on the capital account. In a sense, it is advantageous as the deficit means that the country is enjoying a higher standard of living in the short-term. This is thanks to the higher level of consumption through imports. However, the deficit is being funded by inflows of investment and this will mean interest and dividend payments flowing out of the country in the future. This inward investment also leaves the country more exposed to the whims of external investors. The greater the deficit and the longer it lasts, the more of an issue this will be.

So, consider the question, “Does a deficit on a country’s balance of payments on current account represent an economic problem?” Jot down some points and then follow the link below to compare your answer with ours.

Current account surplus

A current account surplus is less of an issue than a deficit, but it does mean that the country may not be enjoying as high a standard of living as it could be. It would be possible for the economy to boost demand and economic growth without running into a balance of payments deficit. So a current account surplus could be seen as an indication of under-performance.

A current account surplus, under a floating exchange rate system, is likely to exert upward pressure on the exchange rate, with all the problems which that may cause.

Policies to correct a balance of payments deficit

There are two principal types of policy to correct a balance of payments deficit. They are:

1. Expenditure-switching policies – these are policies that are aimed at encouraging people to switch their spending from imported goods to domestic goods. These policies might include tariffs and protectionism in general, manipulation of exchange rates to change the relative prices of imports and supply-side policies aimed at improving the competitiveness of national firms. If these policies are successful, spending will switch from imports to domestic spending and the current account will improve.
2. Expenditure-reducing policies – these are policies that aim to reduce domestic expenditure and therefore reduce the level of imports. The main expenditure-reducing policies are deflationary monetary and fiscal policies. These may include increasing tax, cutting government expenditure or increasing interest rates. The impact of these policies would be to reduce the level of aggregate demand and therefore the demand for imports. Lower income levels mean lower spending on imports and a consequent improvement in the current account. The extent of this improvement will depend on the income elasticity of demand for imports. The higher the income elasticity, the greater the improvement there will be in the current account.

Consequences of a capital account deficit / surplus

A surplus on the capital account means that there are more investment funds flowing into the country than out. This may be to fund a deficit on the current account of the balance of payments. This inward investment may be helpful to the economy and help create jobs and boost growth, but anyone investing in an economy expects a return. This means that a surplus on the capital account will lead to outflows of interest and dividends in the future.

The inflow of funds may exert an upward pressure on the exchange rate as the demand for the domestic currency will increase. This might adversely affect the current account if the increase in export prices makes exports less competitive.

A capital account deficit on the other hand will mean a net outflow of investment funds. This means the country is building up a portfolio of overseas investments, which may lead to future returns of interest, profit and dividends. This may be beneficial in the medium-term. However, short term speculative outflows of funds may have disastrous effects on an economy in terms of the depreciation of the exchange rate, loss of confidence, impact on investment, output and jobs. Several countries in recent years, e.g. Thailand, Indonesia, Russia and Brazil have been badly affected by these speculative outflows of funds.

Terms of trade (TOT)

To simplify the terms of trade, let’s say that we export one good and import just one. Obviously not an exciting situation, but it helps us see how we measure the terms of trade. To make it more interesting, let’s say we export beer and import wine. If 2 units of beer exchange for 1 unit of wine (an exchange ratio or rate of 2/1), then the price of beer will be half that of wine. In other words we can buy 1 unit of wine for every 2 of beer that we export. The terms of trade is therefore 1/2 and we measure it from the formula: price of beer/price of wine (export price/import price). So, the terms of trade is the rate at which one country’s goods exchange against another.

In the real world we export and import a lot more than just wine and beer and goods are rarely exchanged in physical units. International trade is usually carried out through the use of prices. In practice, therefore, the terms of trade is expressed as the price relationship between a country’s imports and exports.

This is usually expressed as an index. This means that any price changes are measured as a percentage change against a base year.

Changes in TOT

The terms of trade is measured from the formula:

Index of export prices / index of import prices x 100

So, if the terms of trade have risen, there can only be a few possible changes. What are these potential changes? Have a think about how export and import prices must have changed and then follow the INCREASE in terms of trade link to compare your answers with ours.

A rise in the terms of trade is generally described as an improvement or favourable movement in the terms of trade. This is because the same volume of exports will now buy more imports, hence potentially improving the standard of living.

Now, what about a fall in the terms of trade? What changes must have happened to export and import prices to cause this? Have a think about this and then follow the DECREASE in terms of trade link to compare your answers with ours.

A decrease in the terms of trade is generally described as a deterioration, worsening or unfavourable movement in the terms of trade as the country can afford fewer imports with the same volume of exports.

The terms of trade is a measure of prices and so how it changes will be determined by demand and supply for the goods and services that are traded. If demand for exports grows significantly, then this is likely to boost export prices and lead to an improvement in the terms of trade. However, this is far from a foregone conclusion as we do need to consider the impact of exchange rate changes on prices as well.

Impact of TOT

Consequences of a change in terms of trade – balance of payments and economy

Changes in the terms of trade will have a significant impact on an economy. For example, many developing countries are very dependent on exports of primary commodities – minerals, agricultural commodities like coffee etc. If prices of these commodities on world markets fall (as has been the case in recent years) then they face a deterioration in their terms of trade. They are earning less from the same volume of exports and this means that they cannot afford to import as much. Their standard of living has fallen, not because of anything they did, but simply due to the vagaries of world markets.

This shows us the main impact of changes in the terms of trade – the effect on the standard of living.

• An improvement in the terms of trade may improve the standard of living in a country – the same volume of exports will buy more imports.
• A deterioration in the terms of trade may reduce the standard of living as more exports have to be sold to pay for the same volume of imports.

However, we also need to take account of the impact on competitiveness of these price changes. If the terms of trade has improved, then this means that export prices have increased more than import prices. This may indicate a deterioration in competitiveness and in the medium term may lead to a fall in export demand. How much export demand falls will depend on the price elasticity of demand for exports. This may adversely affect the balance of payments.

In the same way, a deterioration in the terms of trade may indicate an improvement in competitiveness. This is because import prices have risen more than export prices, perhaps showing that exports are more competitive. In the medium term demand for exports may rise and lead to an improvement in the current account.

So, analysing the terms of trade is not a simple matter. Prices of imports and exports will constantly be changing according to supply and demand and the average changes in these prices will show up in the terms of trade. An improvement in the terms of trade may well be good news for exporters, but are they perhaps less competitive in the medium term as a result? For developing countries that are very dependent on a narrow range of primary exports, the terms of trade will be crucial to their ability to grow and to fund essential imports.

Causes of changes in TOT

Causes of changes in terms of trade – short run and long run

Short run

The terms of trade is the price relationship between a country’s exports and imports and will therefore be influenced by all the factors which determine the prices of imports and exports.

In the short run, changes in relative prices of imports and exports will be caused by fluctuations in exchange rates, particularly where countries operate a floating exchange rate system. Exchange rate volatility may be caused by changes in trade, capital flows, interest rates, speculation, inflation and use of foreign currency reserves by the government (see section 4.6).

You will remember from this section that a depreciation of the exchange rate causes import prices to increase and export prices to decrease, while an appreciation causes the opposite effects.

Also in the short run, there may be considerable fluctuations in the prices of primary commodities which will affect export prices and the terms of trade. These shocks largely occur on the supply-side due to drought, floods, diseases etc. Given that the demand for, and supply of, primary commodities tend to be extremely price inelastic, these supply side changes are likely to have a very pronounced effect on price. We can see this in Figure 1 below.

 

 

Figure 1 Impact on price of primary commodities – supply side changes

In Figure 1, the relative inelasticities of demand and supply have caused a large fall in price in response to the increase in supply from S to S1. Try drawing the same diagram with more elastic demand and supply curves and note the less pronounced effect on price.

Long run

In the longer term, changes in the terms of trade are likely to be determined by those factors which exert a long term influence on the demand for, and supply of, a country’s exports and imports.

For the developing countries, who export mainly primary goods and import manufactured goods, their export prices have tended to fall over time due to a combination of increased supply of and reduced demand for their exports:

• Supply has increased, mainly due to improvements in technology and, in the case of coffee, new producers entering the market.
• Demand has fallen / not risen rapidly for a variety of reasons.

The reasons for demand falling include:

• Development of synthetic substitutes, e.g. plastics have lessened the demand for several raw materials.
• Low income elasticity of demand for primary commodities – as real world incomes have grown, the demand for primary commodities has increased less than proportionately.
• Agricultural protection – the developing countries, despite producing at lower cost, have found it difficult to break into the markets of the richer countries, as farmers there are often heavily subsidised and, in the case of the European Union, protected by a common external tariff.
• Miniaturisation – modern micro chip technologies have enabled products to become smaller, e.g. the personal computer, and this has necessitated less use of raw materials and caused demand to fall.
• Price inelastic demand for exports of primary commodities – compounding the problem of falling export prices, demand for primary commodities tends to be price inelastic, such that decreases in prices bring about less than proportionate increases in the quantity demanded.

The above is in sharp contrast to the situation faced by the more developed countries – the export prices of their manufactured goods has risen over time (high income elasticity of demand, multinational / monopoly control over supply and price) and they have benefited from cheaper import prices of primary commodities due to the factors described above.

Evaluation:

• CRAMPSS
• Long term and Short Term
• Stake Holders
• Pros and Cons