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 index is an improvement, meaning each unit of exports buys more imports. A fall is a deterioration.

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.

Evaluation and Application

Whether a change in the terms of trade is beneficial depends on the underlying elasticities and the cause of the change.

An improved terms of trade does not always improve the current account, because export revenue may still fall if demand is sufficiently elastic.

Commodity exporters provide a useful example. A rise in oil prices can dramatically improve the terms of trade and raise national income for an oil-exporting country.

Exam Preparation