Terms of Trade

1. An improvement means export prices rise relative to import prices, so each unit of exports buys more imports; a deterioration means the opposite.

Calculating the terms of trade

$$ToT=\frac{index\; of\; export\; prices}{index\; of\; import\; prices}\times 100$$

1. A rise in the ratio is an improvement, and a fall is a deterioration.

Factors influencing the terms of trade

1. Relative inflation rates change export prices against import prices.
2. Changes in the exchange rate alter export and import prices, so a stronger currency raises export prices abroad and can improve the terms of trade.
3. Relative productivity changes affect the cost and price of exports.
4. Changes in incomes at home and abroad shift demand for traded goods, so rising world incomes raise demand for a country's exports and can push up their relative price, improving the terms of trade.
5. World commodity prices move the terms of trade sharply for commodity exporters and importers, e.g. Gulf oil exporters such as Saudi Arabia gain when oil prices rise, Latin American exporters such as Chile (copper) and Brazil (soybeans) swing with world prices, while many sub-Saharan African primary-commodity economies are hit hard when the prices they depend on fall.

Impact of a change

1. An improvement means each unit of exports buys more imports, which can raise real purchasing power and living standards if export volumes hold up.
2. But dearer exports can cut the volume sold abroad, and cheaper imports can displace domestic producers.
3. So the effect on the current account of the balance of payments depends on the price elasticity of demand for exports and imports.
4. Commodity-dependent economies feel these effects most: exporters such as Chile (copper) and Brazil (soybeans) enjoy rising national income and a stronger current account in a price boom but face painful adjustment in a slump, whereas manufactured-goods exporters such as China and Germany tend to have steadier terms of trade and are less exposed to commodity price swings.

Is an improvement in the terms of trade always beneficial?

1. It can be beneficial because a country gives up fewer exports for the same imports, raising real national income, which especially helps commodity importers when their import prices fall.
2. But if demand for exports is price elastic, dearer exports cut export revenue and can worsen the current account and cost jobs in exporting industries.
3. On balance it depends on the cause of the change and on elasticities: an improvement driven by higher productivity is more sustainable than one driven by a temporary commodity price spike or a strong currency.