What’s it: Terms of trade (TOT) is the ratio between export prices and import prices. Because international trade involves various goods and services, economists compute them using a price index to represent the average price of exported and imported products.
If a country’s export price rises higher than its import price, it has a positive terms of trade. That means, for the same amount of exports, the country can buy more imports.
The following is the terms of trade data I get from the OECD website.
|OECD – Average||100||101.52||101.16||100.47|
How to calculate the terms of trade
Terms of trade is an indicator of a country’s economic health, especially about the balance of payment. It tells you how many units of export it takes to buy a unit of import.
You can calculate this by dividing the export price by the import price and then multiplying the result by 100.
However, for overall exports, you can use a price index. Exports and imports involve various goods and services, making it challenging to calculate aggregate figures. For this reason, the price index helps you to represent the ratio of average export prices to average import prices.
The following is the terms of trade formula:
Terms of trade = (Average export price index / Average import price index) x 100
If the average export price is higher than the import price, the terms of trade value is more than 100%. That indicates a country accumulates more payments from exports than it spends on imports. Therefore, the country can buy more imports (such as consumer goods and capital goods) with the same number of exports.
Conversely, if import prices rise faster than export prices, the terms of trade worsens. The country must export more goods and services to get the same amount of imported goods. Typically, that leads to lower living standards as imports become more expensive.
Furthermore, you should be careful in concluding this indicator. You need to dig deeper into the factors that cause changes in the terms of trade, including those related to inflation and exchange rates.
Also, you may need to explore the composition of export-import goods and services. You need to examine and understand what causes the increase or decrease in export and import prices.
In general, the terms of trade increases because:
- Export prices rise, and the increase is higher than import prices.
- Export prices rise, but import prices unchanged or fall.
- Export prices fall but at a slower rate than the fall in import prices.
- Export prices are unchanged while import prices fall.
Factors affecting the terms of trade
The terms of trade fluctuates in line with changes in the prices of exported and imported products. And, in the aggregate, it depends on the trend of the domestic inflation rate and inflation abroad.
The exchange rate also affects the terms of trade. International trade involves two currencies as payment, so the price depends on each currency’s purchasing power (exchange rate).
Apart from these two variables, the size and quality of goods also affect the terms of trade.
Depreciation makes the prices of domestic goods cheaper for overseas buyers. The purchasing power of their currency against the domestic currency is stronger.
On the other hand, depreciation indicates a weaker purchasing power of the domestic currency, making imported goods more expensive. Therefore, depreciation leads to a decrease in terms of trade.
Instead, the appreciation of the domestic currency makes the prices of imported goods cheaper for domestic buyers. Meanwhile, for foreign buyers, domestic products are becoming more expensive. For this reason, the terms of trade tends to increase if the exchange rate appreciates.
Product quantity and quality
Larger, higher quality items, such as heavy equipment and industrial machinery, are more expensive than natural products. Say, the domestic economy relies on shipping such goods abroad. On the other hand, the domestic economy relies on imports of primary products such as raw materials.
In that case, the terms of trade should be more than 100%.
A higher inflation rate means that the price of goods and services in the economy increases, including export products. Thus, when the domestic inflation rate is higher than the foreign inflation rate, the terms of trade should be more than 100% (at least temporarily).
Conversely, suppose the foreign inflation rate is higher than the domestic inflation rate. In that case, the price of imported goods is, on average, higher than the price of exported goods. That leads to a decrease in the terms of trade.
Impacts of terms of trade on the economy
When the terms of trade rises, a country can buy more imported goods than before. The country collects more export revenues than import payments, assuming volumes do not change.
Furthermore, the increase in terms of trade has an impact on domestic inflation. For example, suppose an increase occurs because the price of imports is decreasing or rising more moderately than exported goods. In that case, the pressure of imported inflation should decrease.
Meanwhile, a slump in terms of trade lowered living standards. Developing countries are usually vulnerable to this problem. They export commodities and import manufactured goods.
Of course, commodity prices are lower than manufactured goods because they add less value. Therefore, to pay for imports, they have to sell significant quantities of the commodity.
The pressure will be heavier if commodity prices on world markets fall. They face a slump in the exchange rate and have to raise more money to pay for imports. They must increase the volume of imports even more significantly to avoid further deterioration of the exchange rate.