Other things being equal, a rise in a country's terms of trade increases its welfare. What would happen if we relax the ceteris paribus assumption, and allow for the law of demand to operate internationally?

Question

Quizplus · Accepted Answer

The Answer is Let us assume that the terms of trade (or technically the net commodity terms of trade) improve, thus the relative price of a country's exports increase. This would, logically, lead to a shift away by world consumers to substitute goods. If the demand for a country's exports is elastic, the quantity decrease would be proportionally larger than the per unit price increase. This term of trade effect would actually lower the country's real income and economic welfare.

Other Things Being Equal, a Rise in a Country's Terms