# The Effect of Terms of Trade Changes on Welfare in Iceland

Essay 2008 6 Pages

## Excerpt

## Abstract

From 1971 to 2006, terms of trade changes had a negative and rather small effect on welfare in Iceland. For this covered period, the average yearly percentage growth of Iceland’s terms of trade was -0.21%. The time series diagram and the time trend line show this downward trend of Iceland’s terms of trade. The yearly average percentage change in GDP due to terms of trade was -0.05%. This effect is very small compared to the actual 24.34% average annual growth of Iceland's GDP (*EconLit* F110, F140, O470).

A general statement made in Krugman & Obstfeld (2009, p. 93) is that “a rise in the terms of trade increases a country's welfare, while a decline in the terms of trade reduces its welfare”. In this report, I try to analyse the effect of terms of trade changes on welfare in Iceland. To investigate this relationship, I retrieved information on Iceland’s GDP, Export Unit Values (PEX) and Import Unit Values (PIM) for the time period going from 1971 to 2006 (International Monetary Fund, 2008). Amounts are expressed in the national currency, i.e. the Icelandic króna (ISK).

From 1971 to 2006, Iceland's GDP grew from ISK 570mios to ISK

1,167,680mios. Therefore, the average yearly growth of Iceland's GDP during the covered period was:[Abbildung in dieser Leseprobe nicht enthalten] To investigate the effect of terms of trade changes on this average yearly growth, I first used PEX and PIM data to compute the country’s terms of trade for each year of the covered period, using the following equation: [Abbildung in dieser Leseprobe nicht enthalten] where 1971 ≤ i ≤ 2006.

A time series diagram and a time trend line show the evolution of Iceland’s terms of trade from 1971 to 2006 (figure 1). The reference year is 1995 where terms of trade are fixed at a level of 100.

As highlighted by the time trend line in figure 1, terms of trade undergo, globally, a downward movement. Iceland’s terms of trade have shown a lot of volatility during the time period that I have covered. The largest swing observed occurred from 1973 to 1975 when Iceland’s terms of trade dropped sharply from 121.25 to 91.62. Those two values are also respectively the maximum and minimum values observed for the terms of trade during the entire covered period.

The average yearly percentage growth rate g of Iceland’s terms of trade was:[Abbildung in dieser Leseprobe nicht enthalten] where X1971 and X2006 are respectively the fitted values for Iceland’s terms of trade in 1971 and 2006.

This result means that Iceland’s terms of trade have undergone an average annual decrease of 0.21% during the covered time period.

Then, I used imports and GDP of 1989 (i.e. the middle year of the covered period) to approximate the share of imports in Iceland's GDP (SI):

illustration not visible in this excerpt

According to Krugman and Obstfeld (2009) the percentage change in GDP due to terms of trade can be approximated by multiplying the percentage change in the terms of trade with the share of imports in GDP. Therefore, if I apply this formula for Iceland, I obtain:

Effect of Terms of Trade Changes 4

(Yearly average % change in GDP due to terms of trade) ≈ g * SI

illustration not visible in this excerpt

This result means that, with a 25.5% share of imports in its total GDP, Iceland's average annual 0.21% decline of its terms of trade have caused a yearly 0.05% decline of its GDP. This decline of GDP due to terms of trade changes appears rather small compared to the actual 24.34% annual growth of total GDP. Indeed, if terms of trade would have stayed constant during the covered period, the yearly average percentage change in GDP due to terms of trade would have been null. In this case, the annual growth of GDP would have been 24.39%. It appears then that welfare would have been only slightly higher than its actual level when taking terms of trade changes into account.

Therefore, the effect of terms of trade changes has been negative but really small on the welfare of Iceland between 1971 and 2006.

illustration not visible in this excerpt

*Figure 1.* The evolution of Iceland's terms of trade between 1971 and 2006. Year of reference: 1995. *Note.* Data from International Monetary Fund (2008). Time series diagram and time trend line were obtained using the R statistical environment (R Development Core Team, 2008).

## References

International Monetary Fund. (2008). *International Financial Statistics.* Retrieved November 1, 2008, from http://www.imf.org.

Krugman, P.R. & Obstfeld, M. (2009). *International Economics: Theory & Policy* (8th ed.). Boston, MA: Pearson Addison Wesley.

R Development Core Team. (2008). *R: A Language and Environment for Statistical Computing* [Computer software]. Vienna: R Foundation for Statistical Computing. Retrieved from http://www.R-project.org.

**[...]**