Exchange Rate Appreciation Improves Terms of Trade

Steps:

• Terms of trade is the ratio of export prices to import prices; improvement occurs when this ratio rises.
• A rise in the exchange rate (currency appreciation) increases the foreign currency price of exports while lowering the domestic price of imports.
• This widens the export-import price gap, directly boosting the terms of trade ratio.
• Other factors like deficits or inflation affect trade balances but not price ratios as directly.

Why C is correct:

• By definition, terms of trade = (export price index / import price index); appreciation raises export prices in foreign terms, increasing the ratio per the exchange rate pass-through effect.

Why the others are wrong:

• A: Budget deficits influence fiscal policy and demand but do not directly alter relative export-import prices.
• B: Low domestic inflation may help competitiveness but primarily affects current account balances, not terms of trade ratios.
• D: Primary income surplus reflects investment returns, impacting overall balance of payments but not trade price indices.

Final answer: C