4.1.4 Terms of Trade — Practice Questions

Eight original multiple-choice questions on the terms of trade, written to the style and difficulty of Edexcel Paper 2 Section A.

8 questions Edexcel A-Level Multiple choice Model answers included

Not read the notes yet? Start with the 4.1.4 Terms of Trade revision notes.

1. 1. In one year a country's index of average export prices is 115 and its index of average import prices is 92, both against the same base year. Its terms of trade index is

   Calculation

   Select one answer

   A 80.0

   B 92.0

   C 115.0

   D 125.0
   Show model answer

   Answer: D (125.0). The terms of trade index is the ratio of the two price indices, expressed as a number out of 100.
   ToT = (export price index ÷ import price index) × 100
   ToT = (115 ÷ 92) × 100 = 125.0.
   A figure above 100 means export prices have risen relative to import prices since the base year, so each unit of exports now buys more imports than it did. That is an improvement in the terms of trade.

   Why the other options are wrong

   • A — 80.0 divides the import index by the export index — the ratio the wrong way up.
   • B — 92.0 is the import price index on its own.
   • C — 115.0 is the export price index on its own. The terms of trade is the ratio between the two, never one of them.

2. 2. A country's average export prices rise by 4% over a year. Its terms of trade nevertheless deteriorate. This is possible because

   Applied reasoning

   Select one answer

   A Export volumes fell over the same year.

   B Import prices rose by more than 4%.

   C The base year index was above 100.

   D The currency appreciated over the year.
   Show model answer

   Answer: B (Import prices rose by more than 4%.). The terms of trade is a ratio, so what matters is how export prices move relative to import prices — not whether either rises on its own. If export prices rise 4% while import prices rise 9%, the ratio falls, and each unit of exports buys fewer imports than before. Edexcel's worked example makes exactly this point: export prices rose in both of the years shown, and the terms of trade fell in one of them and rose in the other.

   Why the other options are wrong

   • A — The terms of trade is built from prices alone. Volumes affect export revenue, not the index.
   • C — The base year index is 100 by construction — that is what makes it the base year.
   • D — An appreciation raises export prices in foreign currency and lowers import prices in domestic currency, which improves the terms of trade rather than worsening them.

3. 3. Productivity in a country's export industries grows much faster than in its trading partners', and its export prices fall as a result. The effect on its terms of trade is that they

   Applied reasoning

   Select one answer

   A Deteriorate, since export prices have fallen.

   B Improve, since its costs have fallen.

   C Improve, since it is now more competitive.

   D Stay the same, since volumes will rise.
   Show model answer

   Answer: A (Deteriorate, since export prices have fallen.). This is the case students find hardest to accept. Faster productivity growth lowers unit costs, lets exporters cut prices and wins them volume — plainly good for the economy. But the terms of trade measures prices, not competitiveness: lower export prices against unchanged import prices means a lower ratio, so the terms of trade deteriorate. Edexcel lists relative productivity growth as a factor for exactly this reason. A deterioration in the terms of trade is not the same thing as a deterioration in economic performance.

   Why the other options are wrong

   • B — Falling costs are a genuine benefit, but the index does not measure costs. It measures the price of exports relative to imports.
   • C — Improved competitiveness is also genuine, and also not what the index measures — it is precisely by cutting prices that the country becomes more competitive.
   • D — Higher volumes raise export revenue. The index is a price ratio and moves whatever happens to volumes.

4. 4. A country's terms of trade improve sharply because its export prices rise. Demand for its exports is price elastic. The most likely effect on its export revenue is that it

   Applied reasoning

   Select one answer

   A Falls, since volume drops more than price rises.

   B Is unchanged, since the effects cancel out.

   C Rises, since each unit sold earns more.

   D Rises, since the terms of trade have improved.
   Show model answer

   Answer: A (Falls, since volume drops more than price rises.). An improvement in the terms of trade sounds unambiguously good, and is not. Export revenue is price × quantity, and with elastic demand the proportionate fall in quantity exceeds the proportionate rise in price, so revenue falls. That worsens the current account and reduces the contribution of net trade to GDP. Edexcel sets this out as the potential cost of an improvement: the gain in what each unit of exports buys is offset by selling far fewer units of it.

   Why the other options are wrong

   • B — The two effects cancel exactly only at unitary elasticity. The stem specifies elastic demand.
   • C — Each unit does earn more — but far fewer units are sold, and with elastic demand that is the larger effect.
   • D — The terms of trade improving describes the price ratio. On its own it says nothing at all about revenue.

5. 5. A sustained boom in world commodity prices raises the price of a developing country's main export. Its imports are mostly manufactured goods, whose prices are unchanged. Its terms of trade

   Applied reasoning

   Select one answer

   A Are unchanged, since import prices are fixed.

   B Cannot be calculated without volume data.

   C Deteriorate, since it depends on commodities.

   D Improve, since export prices have risen.
   Show model answer

   Answer: D (Improve, since export prices have risen.). The terms of trade is the ratio of export prices to import prices. Export prices have risen and import prices have not, so the ratio rises: the terms of trade improve, and each tonne of the commodity now buys more manufactured imports than before. Edexcel lists changes in global commodity prices among the factors, and notes the effect is particularly sharp for primary-product exporters, whose earnings are concentrated in a small number of commodities.

   Why the other options are wrong

   • A — Import prices being fixed does not freeze the ratio. The numerator has moved, so the ratio has moved.
   • B — The index needs price data only. Volumes affect export revenue, not the terms of trade.
   • C — Depending on commodities is what makes the improvement large, not a reason for a deterioration. The dependence becomes a problem when the boom reverses.

6. 6. A country's inflation runs persistently above its trading partners', and demand for its exports is price inelastic. The likely effect on its terms of trade is that they

   Applied reasoning

   Select one answer

   A Are unchanged, since inflation affects both.

   B Cannot be judged from inflation alone.

   C Deteriorate, since its goods lose competitiveness.

   D Improve, since its export prices rise faster.
   Show model answer

   Answer: D (Improve, since its export prices rise faster.). Higher domestic inflation pushes export prices up faster than import prices, which raises the ratio and improves the terms of trade. Edexcel attaches a condition to it: this is an improvement worth having only where demand for exports is inelastic, so that the higher prices are not paid for in lost volume. Where demand is elastic, the same movement in the index arrives together with a fall in export revenue.

   Why the other options are wrong

   • A — Inflation here is domestic. Import prices are set abroad, so the two do not move together.
   • B — Inflation running above partners' tells you the direction of the ratio, which is what the question asks for.
   • C — Losing competitiveness is a real consequence of faster inflation, but it is not what the terms of trade measures. The index rises.

7. 7. A country's terms of trade index stood at 120.0 last year. Over the following year its export price index rose by 5% and its import price index rose by 20%. To one decimal place, its terms of trade index is now

   Calculation

   Select one answer

   A 102.0

   B 105.0

   C 126.0

   D 137.1
   Show model answer

   Answer: B (105.0). The terms of trade is a ratio of two indices, so a change in it is the ratio of the two growth factors.
   Export prices: × 1.05. Import prices: × 1.20.
   New index = 120.0 × (1.05 ÷ 1.20) = 120.0 × 0.875 = 105.0.
   Export prices did rise — but import prices rose four times as fast, so the terms of trade deteriorated from 120.0 to 105.0. The index is still above the base year, but each unit of exports buys less than it did twelve months ago.

   Why the other options are wrong

   • A — 102.0 subtracts the percentage changes (5% − 20% = −15%) and applies that to the index. The terms of trade is a ratio, so the growth factors divide rather than subtract.
   • C — 126.0 applies only the export price rise and ignores import prices altogether.
   • D — 137.1 divides the import factor by the export factor, which is the ratio upside down.

8. 8. Table 1 lists four changes facing one economy.
   From Table 1, the change that improves its terms of trade is

   Data interpretation

   Table 1: Four changes facing one economy

   	Change
   Change 1	Its currency depreciates against all others
   Change 2	Productivity in its export industries surges
   Change 3	World prices of its main export commodity rise
   Change 4	Its trading partners' inflation exceeds its own

   Select one answer

   A Change 1.

   B Change 2.

   C Change 3.

   D Change 4.
   Show model answer

   Answer: C (Change 3.). The terms of trade improve when export prices rise relative to import prices. Only Change 3 does that: a commodity boom raises the price of what this country sells while leaving the price of what it buys where it was, so the ratio rises.

   Why the other options are wrong

   • A — A depreciation lowers export prices in foreign currency and raises import prices in domestic currency. The ratio falls.
   • B — Faster productivity growth lowers export prices, which worsens the terms of trade even while it improves competitiveness.
   • D — Partners' inflation running above this country's raises import prices faster than export prices, so the ratio falls.