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Impact of Terms of Trade Changes on Open Economies

Question

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.

Category:

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.

Conclusion:
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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