Terms of Trade Adjustment - Gains and Losses from Changes in Terms of Trade

There is a difference between gross domestic product (GDP) at constant prices, and real gross domestic income (GDI). (At current prices GDP and GDI are equivalent). GDP at constant prices is essentially an output volume measure, calculated at the level of the whole economy using a form of double deflation by subtracting imports at constant prices from total final expenditures valued at constant prices. It represents the output of the economy in real terms.

GDI measures total real income which residents derive from domestic production. To derive a real measure of income, a view on the opportunities of where, or on what to spend the money has to be taken. If a country benefits from the rate at which exports are traded against imports from the rest of the world, it will be able to direct the spending power to other areas, so the measure of real income for a country should consider the relationship between exports and imports if the price movements in these two measures are different.

If the prices of a country's exports rise faster than the prices of its imports - if its terms of trade improve - less exports are needed to pay for a given volume of imports so that at a given level of domestic production, goods and services can be re-allocated from exports to consumption or capital formation. An improvement in the terms of trade makes it possible for an increased volume of goods and services to be purchased by residents out of the incomes generated by a given level of domestic production.

GDP from the expenditure side equals the sum of final consumption expenditure, gross fixed capital formation and net exports. GDP at constant prices is derived using the appropriate deflators on each component of GDP. (How to deflate GDP from the expenditure side is described above.) To derive real GDI, considering the measure as an income one, appropriate deflators to reduce the income in nominal terms to real terms has to be used. But what are appropriate deflators?

Considering the income generated by the trade balance (exports - imports), the choice of deflator must depend on the view of to what the income might be spent on if there is a change in the terms of trade, a trading gain or loss. There are several alternative trade balance deflators, like the consumer price index (CPI), the deflator for gross domestic final expenditure, the deflator for net domestic final expenditure, the GDP deflator, the import deflator, or a “mix” between the import and the export deflator (weighted, unweighted). There is no agreement on which deflator is best, and the choice of deflator can sometimes make a substantial difference to the results. The failure to agree on one deflator reflects the fact that no single one is optimal. The choice will depend on whether the current balance of trade is in surplus or deficit, on the size of net export compared to GDP, etc.

To clarify, it might be useful to look at one example on how to estimate the terms of trade effect and the gross domestic income in real terms. The example shows that the size of the terms of trade effect will depend upon the choice of deflator. When choosing which deflator to use, one must make a decision about what the income is to be spent on, since GDI in real terms measures the income's purchasing power.

The example below uses to alternative deflators, the import price index (P^M), and the price index for gross domestic final expenditure (P^DOMESTIC). If the assumption is that the gains in terms of trade will be spent on increased imports only, P^M would be an appropriate deflator, but if the assumption is that the gains in terms of trade will be used on imported goods as well as on products produced within the country, the choice of P^DOMESTIC will be more appropriate.