Terms of Trade

Recent work by Kohli (2002), which examined the impact of terms of trade change on real GDP and real value added, found that real GDP tends to underestimate the increase in real value added and welfare when the terms of trade improve. Kohli found that an improvement in the terms of trade can be viewed as similar to technological progress in that it means, for a given trade balance position, a country can either import more for what it exports, or export less for what it imports. Consequently, an improvement in the terms of trade increases real income, real value added, and welfare. However, the benefits of an improvement in the terms of trade do not show up in the real GDP figures, which focuses on production per se, whereas technological progress does. Kohli notes an improvement in the terms of trade, holding all other prices constant, actually leads to a fall in real GDP due to the GDP deflator increasing.

For example, consider the case in which real GDP is constructed using a Laspeyres index and the price of imports falls (corresponding to a terms of trade increase).[24] Given the lower price of imports, it may be expected that the use of imports as inputs in the production process will increase. However, a Laspeyres index approach uses the earlier period’s prices of imported inputs as weights meaning that the value of inputs will be higher than in some other index approaches and consequently value added will be measured as being lower. The problem with the Laspeyres index is that it is the change in prices that results in a substitution effect but that the price prior to the change is used to construct the index.

Kohli (2002) argued that:

… real GDP can be a very misleading indicator of a country’s welfare in the face of changing terms of trade. It is therefore important to distinguish between real GDP, on the one hand, and real domestic income or real value added, on the other. Real GDP focuses on production possibilities, whereas real income and real value added stress consumption (or more generally absorption) possibilities and, ultimately, welfare. We show that real GDP systematically underestimates growth in real value added when the terms of trade improve. The distinction between real GDP and real value added implies differences between the corresponding price indexes. The implicit GDP deflator, which is obtained by dividing nominal GDP by real GDP, will point at higher inflation than the value-added deflator when the terms of trade improve. In fact, it turns out that a drop in the price of imports, holding all other prices constant, leads to an increase in the GDP deflator.

Kohli, 2002: 2

Source: Table 1 in Kohli (2002).

As shown in Table 1 Kohli found that real GDP severely underestimated growth in real value added for New Zealand, Greece, Italy, Portugal and Switzerland. These countries all experienced significant improvements in their terms of trade over the past two decades. New Zealand’s cumulative growth rates in both the Laspeyres and implicit Törnqvist Real GDP figures were around 41% whereas the implicit Törnqvist Real value added growth was quite a bit higher at over 49%. Real GDP overestimated real value added growth for Mexico, Luxembourg and Norway, which experienced a deterioration in their terms of trade. In the case of New Zealand, it should be noted that most of this effect arose between 1986 and 1991. Since then there has been no discernible trend in the terms of trade.