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Difficulty: Very hardTerms of Trade: Concepts, Calculation, and Determinants

In a given trade cycle, a nation establishes its base year export price index, import price index, and export volume index all at 100100. In the current year, export prices rise by 25%25\%, import prices rise by 50%50\%, and the volume of exports increases by 20%20\%. What is the nation's Income Terms of Trade (ITTITT) for the current year, and what does this imply about its total capacity to import?

  1. 100.0100.0, implying that the nation's overall capacity to import remains unchanged relative to the base year.Answer
  2. B
    144.0144.0, implying that the nation's overall capacity to import has increased by 44%44\% relative to the base year.
  3. C
    83.383.3, implying that the nation's overall capacity to import has declined by 16.7%16.7\% relative to the base year.
  4. D
    103.3103.3, implying that the nation's overall capacity to import has increased by 3.3%3.3\% relative to the base year.

Answer

The Income Terms of Trade for the current year is 100.0100.0, indicating that the nation's total capacity to import remains unchanged compared to the base year.
The Income Terms of Trade measures a country's total capacity to import by adjusting its price ratio (NB TOTNB\,TOT) by the quantity of exports (QxQ_x). Given Px=125P_x = 125, Pm=150P_m = 150, and Qx=120Q_x = 120, the calculation (125150)×120=100.0\left(\frac{125}{150}\right) \times 120 = 100.0 confirms that the physical volume expansion of exports fully counteracts the worsening unit price ratio, leaving the country's overall purchasing power for imports unchanged.

Step-by-Step Solution

1
Calculate the current period export price index (PxP_x) and import price index (PmP_m).
Px=100+(0.25×100)=125P_x = 100 + (0.25 \times 100) = 125; Pm=100+(0.50×100)=150P_m = 100 + (0.50 \times 100) = 150.
Percentage increases are added to the base year index of 100.
2
Determine the current period export volume index (QxQ_x).
Qx=100+(0.20×100)=120Q_x = 100 + (0.20 \times 100) = 120.
The volume of exports expanded by 20% over the base index.
3
Apply the Income Terms of Trade formula: ITT=(PxPm)×QxITT = \left(\frac{P_x}{P_m}\right) \times Q_x.
ITT=(125150)×120=56×120=100.0ITT = \left(\frac{125}{150}\right) \times 120 = \frac{5}{6} \times 120 = 100.0.
Income Terms of Trade measures a country's physical capacity to import based on export earnings.
4
Interpret the resulting index in comparison to the base year value of 100.
Since ITT=100.0ITT = 100.0, the nation's total capacity to import is equal to that of the base year.
An index of 100 signifies no net change in real import purchasing power.

Key Concept

Income Terms of Trade (ITTITT) and Capacity to Import
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Topics

Terms of Trade: Concepts, Calculation, and Determinants

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