The impact of the exchange rate on the terms of trade

The terms of trade index measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports. This is similar to comparing the number of sheep exports that will buy a typical imported family car, from one time to another. See below for formula to calculate terms of teade.

  A “favourable” (increase) in the TOT may come about because the average:  –        export price rose and import price stayed the same –        export prices rose faster than import prices –        export prices stayed the same and import prices fell –        export prices fell but import prices fell faster

What impacts the terms of trade?

Value of the currency – $↑ = XPr↑ MPr↓ therefore an improving terms of trade Value of the currency – $ ↓= XPr↓ MPr↑ therefore a worsening of terms of trade

The worsening terms of trade might impact the lower income groups who are heavily dependent on imported food, fuel and medicines. Additionally firms that import a lot of components parts for their production find that their costs increase (cost push inflation) which impacts their profit margins and may lead to redundancies.

Developed countries: UK, USA, Norway, Luxembourg, Canada and the EU have experienced a higher currency value with a rising terms of trade. This corresponds to higher purchasing power and lower poverty.

Developing countries: China, South Africa Turkiye, Argentina have experienced devaluations in their currency which leads to a deterioration in their terms of trade. This has led to rising relative poverty and declining PPP.

Developing countries and a falling exchange rate

Most low to middle income countries are dependent on the export of their primary products which are elastic in demand. However with protectionist measures in the markets that they sell into, they are forced to devalue their currency to compensate for the tariff on their exports. Export revenue may rise for these countries exporting elastic demand products but there is a double-edged sword in that the cost of servicing foreign debt will be a big burden on the government budget.

Also a devaluation of the currency makes imports more expensive and hence developing countries find it harder to import capital to develop their secondary industry. In contrast the developed economy sells more inelastic high value services which favours a higher exchange rate and there are less substitutes.

Trade vs Devaluations

In theory devaluations should encourage exports and increase employment but in the current environment of trade barriers this may not be the case. Ultimately devaluations erode the terms of trade and purchasing power of domestic consumers which tends to have a greater impact low income countries. In the long term, adopting free trade and comparative advantage may lead to more efficient resource use and cheaper surplus exports. This boosts demand for exports and the country’s currency, potentially improving terms of trade without relying on devaluation.

Source: Economic Review – A level economics Magazine. February 2025

For more on the terms of trade view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.