Terms of trade

3 key takeaways

• Terms of trade (TOT) is the ratio of a country’s export prices to its import prices, reflecting the purchasing power of exports relative to imports.
• An improvement in TOT indicates that a country can buy more imports for a given quantity of exports, while a deterioration means the opposite.
• TOT is influenced by various factors, including changes in global demand and supply, exchange rates, and trade policies.

What are terms of trade?

Terms of trade (TOT) is an economic metric that represents the ratio between the prices a country receives for its exports and the prices it pays for its imports. It is calculated by dividing the index of export prices by the index of import prices and multiplying by 100. This ratio provides insight into the relative value of a country’s exports in terms of the quantity of imports that can be purchased with the revenue from exports.

Importance of terms of trade

Terms of trade are crucial for several reasons:

• Economic Health: TOT reflects the economic health of a country by indicating how much it can afford to import with its export earnings.
• Living Standards: An improvement in TOT suggests that a country can afford more imports for the same amount of exports, potentially leading to higher living standards.
• Trade Balance: Changes in TOT can affect the trade balance, impacting the overall economic stability of a country.

Calculating terms of trade

Terms of trade is typically calculated using the following formula:

Terms of Trade (TOT) = (Index of Export Prices / Index of Import Prices) × 100

Example Calculation

If a country has an index of export prices of 120 and an index of import prices of 100, the terms of trade would be calculated as follows:

TOT = (120 / 100) × 100 = 120

This indicates an improvement in TOT, meaning the country receives more value for its exports relative to its imports.

Factors influencing terms of trade

Several factors can influence a country’s terms of trade:

• Global Demand and Supply: Changes in the global demand and supply for a country’s exports and imports can affect TOT. For example, increased demand for a country’s exports can improve TOT.
• Exchange Rates: Fluctuations in exchange rates can impact the prices of exports and imports, thereby affecting TOT.
• Trade Policies: Tariffs, trade agreements, and other trade policies can influence TOT by altering the prices of exported and imported goods.
• Commodity Prices: For countries that rely heavily on exporting commodities, changes in global commodity prices can significantly impact TOT.

Impact of terms of trade

Changes in terms of trade can have significant implications for an economy:

• Improvement in TOT: When a country’s TOT improves, it means that the country can buy more imports for the same amount of exports. This can lead to better living standards, lower inflation, and increased economic growth.
• Deterioration in TOT: Conversely, a deterioration in TOT means that the country has to export more to afford the same amount of imports. This can lead to higher inflation, reduced purchasing power, and potential economic challenges.

Examples of terms of trade

Consider two countries, Country A and Country B:

• Country A: Export prices increase due to high global demand for its technology products, while import prices remain stable. This leads to an improvement in Country A’s TOT, allowing it to import more goods for the same value of exports.
• Country B: Export prices decrease due to a drop in global oil prices, while import prices increase due to rising costs of manufactured goods. This results in a deterioration of Country B’s TOT, requiring it to export more oil to afford the same amount of imports.

Terms of trade in economic analysis

Economists and policymakers closely monitor TOT as it provides valuable insights into a country’s trade dynamics and economic health:

• Policy Decisions: Changes in TOT can inform trade and economic policies, such as adjustments in tariffs, subsidies, and exchange rate management.
• Economic Forecasting: TOT trends can help forecast future economic conditions, including trade balances, inflation rates, and GDP growth.

Terms of trade is a vital economic indicator that measures the relative value of a country’s exports to its imports. By understanding and analyzing TOT, countries can make informed decisions about trade policies, economic strategies, and overall economic health.