What is the Effect of Economic Development on the Terms of Trade?

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Economic development uplifts the production possibility frontiers of a country. Economic growth thus implies an increase in the country's gross product (GNP). With economic development, per capita income also increases.

As a result of change in income, the income elasticity of demand for imports may change. The direction of change of the terms of trade with economic development is determined by the effect of growth on the net demand for imports. Rising income probably cause an increase in the demand for goods of imports. But, due to economic growth the domestic production (supply) of these otherwise importable may also increase.

The former effect of economic growth is described as income elasticity of demand. It may be defined as the percentage change in the consumption of importable divided by the percentage change in the total real income. Both the effects are to be measured a constant relative commodity prices. The net effect of growth is combined result of these supply and demand effects:

1. When the income elasticities of demand for the supply of importables are equal to unity, their combined effect will cause an adverse change in the terms of trade, because there will be a net rise in the demand for imports.

2. If the income elasticity of demand is greater than unity but that of supply is less than unity, then also the terms of trade will change adversely with economic development as there will be a net rise in the demand for importables.

3. When the income elasticity of demand is less than unity but that of supply is greater than unity, the terms of trade will improve with growth, because there will be a net fall in the demand for importables.

4. If the income elasticity of demand is greater than unity and that of supply is also greater than unity, the net effect of growth depends on the relative size. If there is a net rise in the demand for importables the terms of trade will improve. The same logic applies to the case of elasticities being less than unity.


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