Terms of Trade

This section explains terms of trade, exploring the calculation of terms of trade, factors influencing a country's terms of trade and the impact of changes in a country's terms of trade.

In the evolving landscape of international economics, the terms of trade (ToT) remains a pivotal concept for understanding not only how nations interact through trade, but also how changes in global markets can influence economic outcomes. 

Calculation of Terms of Trade

The terms of trade is an index that measures the relative price of a country’s exports compared to its imports. It indicates how many units of imports a country can receive per unit of export, offering insight into a nation’s trading position on the world stage.

Formula for Calculating Terms of Trade

The standard formula for calculating the terms of trade is as follows:

Terms of Trade (ToT) Index = (Index of Export Prices ÷ Index of Import Prices) × 100

For example, if the export price index for a country is 120 and the import price index is 100, the terms of trade would be:

ToT = (120 ÷ 100) × 100 = 120

A ToT index above 100 indicates that export prices have risen relative to import prices since the base year, whereas an index below 100 would suggest a decline in the value of exports relative to imports.

Worked Example

Suppose Country X exported cars with an index price of 110 and imported crude oil with an index price of 95.

ToT = (110 ÷ 95) × 100 ≈ 115.8

This means Country X can obtain more imports for every unit of export compared to the base year, suggesting an improvement in its terms of trade.

Interpretation

An improvement in the terms of trade means a country can purchase more imports for a given quantity of exports, which may reflect increased export prices, decreased import prices, or a combination of both. Conversely, a deterioration implies the country must export more to purchase the same quantity of imports.

Factors Influencing a Country's Terms of Trade

The terms of trade for any given country is shaped by a variety of both domestic and international factors. These factors can shift over time, influencing the relative prices of exports and imports.

• Relative Inflation Rates: If a country experiences higher inflation than its trading partners, its export prices may rise faster than import prices, potentially improving its terms of trade. However, if exports become less competitive, the country may lose market share.
• Changes in Exchange Rates: An appreciation of the national currency makes imports cheaper and exports relatively more expensive. This may improve the terms of trade but could reduce export volumes. Conversely, a depreciation tends to worsen the terms of trade by making imports more expensive.
• Global Demand and Supply Conditions: Shifts in demand for a country’s exports or changes in the supply of its imports can significantly alter terms of trade. For instance, a surge in global demand for technological goods or commodities exported by a country often raises export prices, improving the terms of trade.
• Productivity and Technological Advancements: Improvements in productivity can reduce the cost of producing exports, potentially lowering export prices if the savings are passed on. However, if productivity increases lead to higher quality or differentiated goods, export prices may rise, improving terms of trade.
• Trade Policies and Tariffs: The imposition of tariffs or trade barriers can affect the prices of imports and exports, thereby impacting terms of trade. For example, higher import tariffs may discourage imports, potentially improving ToT for the imposing country.
• Commodity Prices: For countries reliant on the export of primary commodities such as oil, metals or agricultural products, global commodity price volatility can cause substantial swings in terms of trade.
• Income Levels in Trading Partners: Rising incomes in trading partners may increase demand for exports, pushing up export prices and improving terms of trade for the exporting country.
• Structural Changes in the Economy: Long-term changes such as industrialisation or diversification of the export base can influence the prices and types of goods traded, thereby affecting the terms of trade.

Impact of Changes in a Country's Terms of Trade

Changes in terms of trade have broad implications for an economy, affecting domestic output, living standards, balance of payments, and long-term economic growth.

• Standard of Living: An improvement in terms of trade means a country can buy more imports for a given level of exports, potentially raising its standard of living. Cheaper imports can also lead to lower production costs for firms and a greater variety of goods for consumers.
• Current Account Balance: Improved terms of trade may increase export revenue relative to import expenditure, strengthening the current account. However, if higher export prices reduce demand for exports, the effect may be offset.
• Economic Growth: Enhanced terms of trade can stimulate economic growth by increasing national income. Export-led growth is particularly significant for developing economies reliant on a few key export commodities.
• Income Distribution: Changes in the terms of trade can influence income distribution within a country, especially in economies reliant on primary commodities. A deterioration may harm producers in export sectors while benefiting consumers if import prices fall.
• Inflationary Pressures: Deteriorating terms of trade (where import prices rise faster than export prices) may lead to imported inflation, increasing the general price level and reducing purchasing power.
• External Debt: Countries with worsening terms of trade may experience higher external debt burdens, as they need to export more to finance the same quantity of imports and repay foreign loans.

Case Study: Commodity Exporters

Many developing countries depend heavily on the export of a narrow range of commodities. When global commodity prices fall, the terms of trade deteriorate, often leading to balance of payments crises, reduced government revenues, and lower living standards. For example, oil-exporting nations have experienced significant volatility in their terms of trade due to fluctuating world oil prices.

Marshall-Lerner Condition

It is important to note the Marshall-Lerner condition in evaluating the impact of exchange rate changes on the current account. It states that a depreciation will only improve a country’s trade balance if the sum of the price elasticities of demand for exports and imports is greater than one.

Summary

The terms of trade is a central concept in international economics, reflecting the relative pricing power of nations in the global marketplace. Its calculation, the factors influencing its movement, and the impact of such changes are essential knowledge for  Economics students seeking a global economic perspective. Understanding these dynamics equips students to analyse trade patterns, assess the effects of economic shocks, and evaluate policy responses in a complex, interconnected world.