The sky’s the limit: The economics of inflation and hyperinflation

3 The terms of trade

The existence of international trade means that foreign suppliers and consumers comprise another set of economic actors with claims over the value of domestic output, and whose interests conflict with domestic residents.

For example, take Chile and South Korea. Copper comprises more than 40% of Chile’s exports, and Chileans use the proceeds to buy a range of imports such as cars from South Korea. Thus through international trade, copper can be ‘transformed’ into cars at the going relative price. A conflict of interests arises because a decline in the price of copper would be bad news for Chile but good news for South Korea, who imports copper from Chile.

terms of trade

A country’s terms of trade are measured by the ratio of the export price to the import price. When the price it receives for exports falls relative to the price it pays for imports, we say that its terms of trade have deteriorated.

The implied conflict is reflected in the terms of trade (ToT). This is defined as the average international price of a country’s exports, \(P_X^*\), relative to the average international price of its imports, \(P_M^*\), both denominated in foreign currency. Thus

\[\text{ToT} = \frac{P_X^*}{P_M^*}\]

A decline in the terms of trade means that the home country’s imports have become more expensive relative to its exports, and it implies that the country becomes poorer (that is, it has reduced purchasing power). The foreign sector has increased its claim over domestic output, meaning there is less left for domestic workers and firms to distribute between themselves.

In Chile’s case, from 2011 to 2016 the price of copper declined by 45%. Compared to 2011 it would take nearly twice as much copper in 2016 to buy one of those cars (assuming the price of cars remained constant), implying a decline in the rate at which Chile could transform copper into cars. Taking into account all traded goods, the overall price of Chile’s exports fell by 15% relative to the price of Chile’s imports. A given quantity of its exports could now be transformed into 15% fewer imports.

To learn more about negative supply shocks, read Section 4.9 of The Economy 2.0: Macroeconomics.

A negative terms-of-trade shock acts like a negative supply shock because we can think of trade as a way to transform our exported goods into the imported goods that we want to consume. In Chile, real GDP growth dropped from over 6% to under 2% over that period, and in 2014 and 2015 inflation rose above 4% for the first time since the global financial crisis of 2007–2009.

Why does a negative terms-of-trade shock raise inflation?

First, the decline in the terms of trade will raise the price of imports. This also implies a ‘pass-through’ effect as domestic firms that use imported inputs in their own products will raise their prices in order to maintain their profit margins. Both of these effects imply a one-off increase in the price level, and are referred to as the ‘first-round effects’.

If inflation expectations are adaptive, this can lead to ongoing and rising inflation following the mechanisms we discussed in Section 2. Prices have risen while nominal wages have not, implying a downward shift in the PS curve: it moves down proportionally with productivity. With the WS curve constant, this opens up a bargaining gap at the original level of unemployment. The result is a rise in the Phillips curve because inflation is higher (the bargaining gap is larger) at any given unemployment rate. If unemployment does not rise to close the bargaining gap, this sets off a wage–price spiral because workers will update their inflation expectations in the next wage-setting round. This is known as the ‘second-round effect’.

If expectations are anchored to a credible inflation target, then the second-round effect will not occur. If the terms-of-trade shock is temporary, then it is equivalent to the temporary negative supply shock explored in Exercise 2 in Section 2, which demonstrates the difference made by anchored versus adaptive expectations.

If the shock is long-lasting, however, matters are more complicated. First, the real economy does not recover its level of total productivity, so in the WS–PS model, both productivity and the PS curve (and hence real wages) remain depressed. Second, anchored expectations will not last long if higher inflation is not dealt with swiftly.

In this case there are only two ways to close the bargaining gap and avoid higher inflation in the longer run. The first is sustaining higher unemployment, which is highly costly to the economy and its inhabitants. The second is a downward shift in the WS curve, meaning workers have to accept the new, lower, level of real wages and be willing to keep working without the increased threat of unemployment. This is much less costly because it lowers unemployment, but may be hard to achieve—there are no simple policy tools for encouraging households to accept that they are poorer.

We can understand why the two conditions, anchored inflation expectations and acceptance of lower real incomes, are required by referring to our inflation equation:

\[\pi_t = \pi_t^E + \text{gap}_t\]

If inflation expectations are anchored at the inflation target \(\pi^T\) then \(\pi_t^E = \pi^T\), and if the PS and WS curves can cross at the current unemployment rate then \(\text{gap}_t = 0\). In this case, a rise in inflation and a fall in potential output at time \(t - 1\) does not lead to higher inflation at time \(t\). The Phillips curve rises for year \(t - 1\) as the first-round effects cause a one-off rise in prices that year, but it falls back for year \(t\), meaning there is no second-round effect of a wage–price spiral.

In the case of Chile, the negative terms-of-trade shock was temporary, and the country succeeded in avoiding a wage–price spiral while it lasted: inflation rose above 4% in 2014 and 2015, and by 2017 it was back below 3%.

For further discussion of this episode, read Section 4.11 of The Economy 2.0: Macroeconomics.

This also occurred in the case of the rise in global inflation that occurred in 2021–2023. There were a multitude of causes for the rise in global inflation: supply constraints due to COVID-19 in China constrained international trade, followed by the war in Ukraine, which raised international prices of wheat, combined with the release of pent-up demand from COVID-19 lockdowns around the world. Many people who had spent little money during the pandemic suddenly wanted to spend more, at the same time that supply was reduced. Inflation rose well above target in high-income countries like France, Germany, the UK, and the US. But by 2024 inflation had fallen back to target levels in many of these countries, suggesting that the first-round effects did not lead to the feared second-round effect of the wage–price spiral, and that inflation expectations remained anchored.