4.1.4 - Terms of trade

What Terms of Trade Measure

The terms of trade refers to the rate at which a country's exports exchange for its imports. In practice, that means the purchasing power of exports: how many imports can be bought from the sale of a given amount of exports.

If export prices rise relative to import prices, there is an improvement in the terms of trade. That is a favourable movement because the same exports can command more imports. If import prices rise relative to export prices, there is a deterioration in the terms of trade. That is an unfavourable movement because the country has to export more to afford the same imports.

One common confusion is to treat terms of trade as if it measures how much a country trades. It does not. A country could have improving terms of trade but falling export volumes, or deteriorating terms of trade but rising export revenue.

Calculating the Index

Economists do not compare one export price with one import price, because countries buy and sell thousands of goods and services. Instead, they use weighted average price indices. The base year is set equal to 100, and later values show how export and import prices have changed relative to that starting point.

Here is a compact worked example:

In Year 2, export prices have risen faster than import prices, so there is an improvement in the terms of trade. In Year 3, import prices have risen faster than export prices, so there is a deterioration. The calculation matters, but the interpretation matters just as much.

Why Terms of Trade Change

Anything that changes export prices or import prices can change the terms of trade.

In the short run, exchange rates are a major influence. An appreciation tends to improve the terms of trade because imports become cheaper in domestic currency while exports become more expensive to overseas buyers. A depreciation usually does the opposite.

Relative inflation also matters. If domestic inflation is higher than inflation in trading-partner countries, export prices may rise relative to import prices, so the terms of trade may improve on paper. But that does not automatically mean the economy is stronger, because exporters may have become less competitive.

Changes in world demand and supply matter as well. Stronger global demand for a country's exports can push export prices up. A rise in the world supply of imported food, fuel or manufactured goods can push import prices down. Both would improve the terms of trade. The reverse movements would cause deterioration.

In the longer run, productivity changes can have the opposite effect to what students first expect. If a country becomes more productive, its firms may be able to cut export prices. That can cause a deterioration in the terms of trade even though competitiveness has improved.

The composition of exports matters too. As world incomes rise, demand for higher-value services and manufactured products may rise faster than demand for basic primary commodities, because their income elasticity of demand is higher. Countries selling tourism, finance or advanced manufactures may therefore see stronger export prices than countries relying heavily on raw materials.

The Prebisch-Singer hypothesis takes this further. It argues that over time the prices of primary products tend to rise more slowly than the prices of manufactured goods, mainly because demand for primary products is income inelastic, so it grows only slowly as world incomes rise. That means countries with primary product dependency may experience long-run deterioration in their terms of trade, which can make development harder.