Terms of Trade
Definition and Calculation
The terms of trade (ToT) measures the relative price of a country's exports compared with its imports.
\[ \text{Terms of Trade Index} = \left( \frac{\text{Index of Average Export Prices}}{\text{Index of Average Import Prices}} \right) \times 100 \]
Interpretation: A rise in the terms of trade index indicates that a country can buy more imports for each unit of exports, which is generally considered an improvement in the terms of trade. Conversely, a fall in the terms of trade index indicates that a country can buy fewer imports for each unit of exports, which is generally considered a deterioration in the terms of trade
Worked Example: Calculating the Terms of Trade
A country's average export and import prices are recorded as index numbers, with Year 1 as the base year:
| Year | Export price index | Import price index | Terms of trade |
|---|---|---|---|
| Year 1 (base) | 100 | 100 | \( \frac{100}{100} \times 100 = 100 \) |
| Year 2 | 106 | 112 | \( \frac{106}{112} \times 100 = 94.6 \) |
| Year 3 | 115 | 110 | \( \frac{115}{110} \times 100 = 104.5 \) |
In Year 2 the index falls to 94.6: import prices rose faster than export prices, so each unit of exports buys fewer imports. In Year 3 it rises to 104.5. Note that export prices rose in both years - what moves the terms of trade is the ratio of the two indices, not the direction of either one on its own.
Factors Influencing the Terms of Trade
- Relative inflation rates: Higher inflation than trading partners may raise export prices and improve the terms of trade if demand is inelastic.
- Relative productivity growth: Faster productivity growth can lower export costs and prices, which may worsen the terms of trade.
- Changes in exchange rates: An appreciation tends to make exports more expensive and imports cheaper, which tends to improve the terms of trade.
- Changes in global commodity prices: A boom in commodity prices can sharply improve the terms of trade for primary-product exporters.
- Changes in demand: Stronger global demand for a country's exports may raise export prices and improve the terms of trade.
Impact of Changes in the Terms of Trade
The effects depend heavily on the price elasticity of demand (PED) for exports and imports.
Improvement in the Terms of Trade
This happens when export prices rise or import prices fall.
Potential benefit: Each unit of exports buys more imports, which may improve living standards.
Potential cost: If export demand is elastic, the rise in export prices may cause a large fall in export volumes, reducing export revenue and worsening the current account and GDP.
Deterioration in the Terms of Trade
This happens when export prices fall or import prices rise.
Potential cost: More exports are needed to buy the same volume of imports, which may reduce living standards.
Potential benefit: If export demand is elastic, lower export prices may cause a large rise in export sales, increasing export revenue, GDP, and employment.
Test yourself on this topic
Eight original multiple-choice questions on calculating the terms of trade, the factors that move it, and its effects on revenue and living standards.
Practice Questions: 4.1.4 Terms of TradePast paper questions on this topic
One question on Terms of Trade from the Edexcel A-Level papers, 2018, worth 5 marks. It links straight to the page of the official mark scheme where its answer begins.
Past Paper Questions: 4.1.4 Terms of Trade