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IAI Actuarial Core Principles · Business Economics · Importance of international trade

Country X exports mainly tea and imports mainly machinery. Over five years the world price of tea falls 20% while the price of machinery is unchanged, and X's export volume rises 30%. Starting from a base of 100 for all indices, which statement is correct?

Terms of trade fall to 80 (80/100 x 100), but the income terms of trade are 80 x 130/100 = 104. Export volume growth more than offsets the price fall, so the country's capacity to import from export earnings has actually increased.

  1. ATerms of trade fall to 80, but the income terms of trade (terms of trade x export volume index/100) rise to 104Correct
  2. BTerms of trade fall to 80 and income terms of trade fall to 80
  3. CTerms of trade rise to 125, and income terms of trade rise to 162.5
  4. DTerms of trade stay at 100, but income terms of trade rise to 130
  5. Terms of trade fall to 80, and income terms of trade rise to 110

Explanation

Export price index 80, import price index 100, so terms of trade = 80. Income terms of trade = 80 x 130/100 = 104. So the purchasing power of exports in terms of imports has risen despite worse price terms. Option 4 ignores the price fall; option 2 ignores volume.

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