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The Terms of Trade

The terms of trade reflects changes in the relative prices of two sets of products. These may be the prices of clothing compared to the prices of foodstuffs. But, most commonly, the terms of trade refer to the prices of commodities and compare these to the prices of manufactured products – the “manufactures-commodities terms of trade”.

Historically, and for very long periods, the terms of trade have tended to turn against commodities and in favour of manufactures. Of course the issue is more complex than this since there are many types of commodities, and many different types of manufactures. But, nonetheless, this long-term trend has been persistent, at least since the 1870s, and probably even earlier than that.

Fall in terms of trade
There are a number of reasons why the terms of trade have fallen:

  • As incomes grow, higher-income consumers tend to spend more on manufactures than on commodities
  • Synthetic substitutes are developed for commodities (as in the case of rubber)
  • Supplies of commodities have been abundant
But in recent years we have witnessed a period of terms-of-trade reversal, that is, the price of commodities have been rising more rapidly than those of manufactures. A prime cause of this reversal has been the growth of the two giant Asian Driver economies – China and India.
  • China’s demand for meat-based foods has pushed up the prices of many agricultural commodities
  • China and India’s manufacturing sectors have incorporated many minerals
  • China and India’s expanding infrastructure has massively increased their demand for many commodities
  • Their growing consumption of energy in China and India has pushed up the price of oil and gas.

Commodity Price Booms
Will this change in the terms of trade since 2001 be sustained? Economists distinguish three types of commodity price booms:
  • Cyclical changes –in the early 1950s and early 1970s there were short-run changes in the price of many commodities; in some cases, droughts or frosts have also pushed up the price of particular agricultural crops for a short period
  • Super-cycles – as in the current period, commodity prices have boomed for a longer period
  • Structural breaks – this represents a long-run shift in the terms of trade

Current thinking suggests that, at the very least, the present boom represents a super-cycle. But, largely because of the rise of China and India’s economies, and particularly due to their continuing investments in infrastructure, the terms of trade may also be encountering a structural shift. In the case of some commodities – notably “peak oil” – there may also be long-run limits to availability.