Effects of change in the Terms of Trade (TOT)
Key macro shock: change in the TOT. Effects on production, consumtion, exports and imports, and welfare. If TOT is in favor of SOE, welfare rises but if it is against welfare falls
Effects depend on which good is initially imported. Income and substitution effects are an important element in analyzing the implications of a change in the terms of trade.
Case 1: good a is imported
– If TOTab ↑, Production of good a ↑ and production of good b ↓.
– Consuption of a ↓ and consumption of b?-Negative income effect
– Imports of good a ↓ and exports of b ?
– Wefare falls
The term of trade increase with the price of good a increasing relative to good b. When good a is initially imported, welfare falls. The subtitution effect on consumption is the movement from B to F, the income effect movement from F to E. Consumption of good a falls, and consumption of good b may risse or fall. The production point moves from A to D (see figure bellow).
Case 2: good b is initially imported
– If TOTab ↑, Production of good a ↑ and production of good b ↓
– Consumption of a? and consumption of b ↑-Positive income effects
– Imports of b? and exports of a?
– Welfare improves
An increase in the terms of trade increases welfare when good b is initially imported. Substitution effect on consumption is the movement from B to F, the income effect is the movement from F to E. Consumption of good a may rise or fall, and consumption of good b rises. Production moves from A to D (see figure bellow).
International Trade in Goods and Assets – “Macroeconomics” by Stephen D. Williamson