Inferior good and terms of trade - Banking Diploma Education

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Sunday, February 16, 2014

Inferior good and terms of trade

Q.  Explain Inferior good with example (Nov’10, May’12).
Inferior good:  A type of good for which demand declines as the level of income or real GDP in the economy increases. This occurs when a good has more costly substitutes that see an increase in demand as the society's economy improves. An inferior good is the opposite of a normal good, which experiences an increase in demand along with increases in the income level.
An example of an inferior good is public transportation. When consumers have less wealth, they may forgo using their own forms of private transportation in order to cut down costs (car insurance, gas and other car upkeep costs) and instead opt to use a less expensive form of transportation (bus pass).

Q. Define Terms of Trade (May’11, Dec’12 and Dec'13).
Terms of Trade: The Terms of Trade measures the relative price of exports compared to the price of imports.
Terms of Trade = 100 * Average export prices / Average Import prices.
Basically, the terms of trade refers to how many exports will need to be sold in order to be able to purchase imports.

i) If the price of exports increases, there will be an improvement in the terms of trade.


ii) If the price of exports falls, there will be a decline in the terms of trade.

Importance of the terms of Trade: To some extent we can use the terms of trade to measure the strength and well-being of an economy. A prolonged fall in the terms of trade will reduce living standards. The US, will find that it can increasingly purchase less imports from abroad. But, at the same time it is also quite limited. For example, devaluation doesn’t necessarily harm a country. Devaluation does make exports more competitive and can increase economic growth.

There is much more to the strength of an economy than the terms of trade.
For example:
    Volumes of trade
    productivity
    capital flows
    economic growth

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