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Impact of Terms of Trade Changes on Open Economies


Assess whether a rise or a fall in the terms of trade will benefit the macroeconomic performance of an open economy that is heavily dependent on international trade.


International Trade and Exchange Rates

AS Level Cambridge 2023 Paper 22

Preview Answer

Understanding Terms of Trade:
Terms of Trade (ToT) measure a country's export prices relative to its import prices.
A rise in ToT signifies improved trade conditions, while a fall indicates a weaker position.

Impact of a Rise in Terms of Trade:
Lower Inflation: Decreased import prices can stabilize inflation.
Economic Growth and Employment: Higher export income can fuel growth and job creation.
Current Account Deficit: Increased export prices may reduce competitiveness, leading to deficits.

Impact of a Fall in Terms of Trade:
Boost in Exports: Lower export prices may increase demand, stimulating growth.
Current Account Improvement: Higher export volumes can enhance the trade balance.
Economic Weakness: Reduced demand for exports might signal underlying economic issues.

Evaluating Effects:
Price Elasticity of Demand and the Marshall-Lerner Condition are critical factors.
Balancing Benefits and Drawbacks: Both rises and falls in ToT have pros and cons.
Dependency on International Trade: Impact is more significant for economies heavily reliant on trade.

The impact of ToT changes depends on various factors, including trade structure and demand elasticity.
Policymakers must carefully assess these factors to harness benefits and mitigate risks.

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