Terms of trade is a vital concept in international economics, indicating the relative prices of exports compared to imports and reflecting a country's trading position.
What is Terms of Trade?
Terms of trade (ToT) is a measure used to determine how much a country gains from international trade. It refers to the rate at which a country's exports are exchanged for imports. More specifically, it tells us the amount of imports a country can purchase per unit of exports. This measure provides insight into a country’s purchasing power in the global market and the extent to which trade contributes to its economic welfare.
An improvement in the terms of trade occurs when a country can buy more imports for the same quantity of exports. Conversely, a deterioration in the terms of trade means that more exports are needed to buy a given amount of imports.
A change in terms of trade can significantly influence a country’s standard of living, trade balance, rate of inflation, and development potential, making it a key concept in international economics and macroeconomic analysis.
How to Calculate Terms of Trade
Terms of trade is calculated using a straightforward formula involving price indices:
Terms of Trade (%) = (Index of Export Prices / Index of Import Prices) × 100
Export Price Index measures the average change in the prices of goods and services sold abroad.
Import Price Index measures the average change in the prices of goods and services bought from abroad.
Example:
If a country's export price index is 120 and its import price index is 100:
Terms of Trade = (120 / 100) × 100 = 120
This result indicates an improvement in the terms of trade, meaning the country can now obtain more imports for each unit of exports compared to the base year.
If the export price index falls to 95 while the import price index remains at 100:
Terms of Trade = (95 / 100) × 100 = 95
This shows a deterioration in the terms of trade, reducing the country’s purchasing power on the international stage.
Factors Influencing Terms of Trade
Several interlinked factors can influence a country’s terms of trade. These factors often operate simultaneously and may push the ToT in different directions. The effect also depends on the type of goods traded, economic structure, and external economic conditions.
1. Global commodity prices
Countries that are major exporters of commodities such as oil, metals, or agricultural goods are highly sensitive to shifts in global commodity prices.
A rise in the global price of a country’s main export improves its export price index, improving the ToT.
A fall in commodity prices can severely damage export revenue, leading to a deterioration in the ToT.
This is particularly important for developing economies that are heavily dependent on a small number of export goods.
2. Exchange rate movements
Fluctuations in the exchange rate can alter the relative prices of imports and exports.
An appreciation of the domestic currency makes imports cheaper and exports more expensive. This can improve the ToT if import prices fall faster than the decline in export demand.
A depreciation makes imports more expensive and exports cheaper. This often worsens the ToT, although it may boost export volumes.
Exchange rate changes can have both price and volume effects, and the overall impact on ToT depends on the elasticity of demand for exports and imports.
3. Inflation rates
If a country has a higher inflation rate than its trading partners, its export prices may rise faster than import prices.
This can lead to a short-term improvement in ToT but may reduce demand for exports due to reduced competitiveness.
If inflation affects imports more than exports (e.g. rising global food prices), ToT may deteriorate, increasing domestic inflation pressures.
4. Productivity and technology
Changes in productivity and technological innovation can alter the relative costs and prices of traded goods.
Higher productivity may lower export prices, which could worsen the ToT.
However, greater productivity can also make a country’s exports more attractive, increasing demand and export volume, potentially offsetting price reductions.
Technological advancement in the production of manufactured goods has historically benefited countries with diversified, high-value exports, often at the expense of primary-exporting nations.
5. Trade policy
Tariffs, subsidies, and non-tariff barriers can influence the prices of both exports and imports.
Protectionist policies may raise domestic prices, potentially improving the export price index and thus the ToT.
On the other hand, trade liberalisation might reduce prices through increased competition, which could deteriorate the ToT but raise consumer welfare.
Countries engaging in preferential trade agreements may also see ToT effects due to changes in trade terms and prices.
Impacts of Changes in Terms of Trade
Fluctuations in the terms of trade have significant implications for a nation’s macroeconomic performance and economic development. These effects can be short-term or long-term and vary depending on a country’s economic structure, especially its trade dependencies and the elasticity of demand for its imports and exports.
Improvement in terms of trade
An improvement in the ToT means a country can obtain more imports for the same volume of exports.
Economic impacts:
Higher real national income: A better ToT improves purchasing power and allows for greater consumption of imported goods and services.
Improved living standards: Consumers can access a wider range of goods at better prices.
Lower cost of imported inputs: Helps reduce production costs, especially in manufacturing and services.
Inflation control: Lower import prices reduce cost-push inflation pressures.
However, it can also have negative side effects:
Reduced export competitiveness if the ToT improvement stems from rising domestic prices.
Falling export volumes if international buyers seek cheaper alternatives.
Deterioration in terms of trade
A deterioration means that a country must export more to afford the same level of imports. This often results from falling export prices, rising import prices, or both.
Economic impacts:
Reduced real income: The economy must divert more resources to export production, limiting consumption and investment possibilities.
Higher import costs: Can lead to inflation, especially where imports include essential goods such as energy, food, or raw materials.
Worsening current account: If import demand remains inelastic, the trade deficit may increase.
Fiscal pressure: Lower export earnings reduce tax revenues and foreign reserves, affecting public finances.
Effects on the trade balance
The effect of changes in ToT on the balance of trade is nuanced.
An improvement in ToT (due to higher export prices) may worsen the trade balance if the quantity demanded for exports falls significantly.
If demand is price inelastic, higher export prices can increase export revenues and improve the trade balance.
A deterioration in ToT may lead to increased export volumes (if cheaper exports attract more buyers), potentially offsetting the price fall.
Marshall-Lerner condition helps assess whether a depreciation or ToT deterioration improves the trade balance, depending on demand elasticities.
Effects on inflation
Import price increases can feed into domestic prices, creating cost-push inflation, especially for food and fuel.
Improved ToT, where import prices fall, can help ease inflationary pressure and reduce input costs for producers.
Effects on development potential
Terms of trade changes have deep implications for long-term economic development, particularly in developing countries.
Improved ToT:
Higher export revenue supports public investment in health, education, and infrastructure.
Enhances debt repayment capacity and reduces dependency on foreign aid.
Encourages foreign direct investment (FDI) due to stronger and more stable economic conditions.
Deteriorated ToT:
Constrains fiscal space and limits development expenditure.
Increases external borrowing, raising debt burdens.
Reduces human development outcomes through limited access to essential imports and services.
Additional Considerations
Elasticity of demand and the ToT effect
The impact of ToT changes depends heavily on the price elasticity of demand for exports and imports.
If demand is inelastic, price increases may raise total revenue, even with lower quantity.
If demand is elastic, price increases may lead to falling total revenue, worsening the trade balance.
Countries exporting necessities (e.g. oil, coffee) often face inelastic demand, benefiting more from price increases.
Prebisch-Singer hypothesis
This theory suggests that over time, the ToT for countries exporting primary commodities tends to deteriorate relative to those exporting manufactured goods. This occurs due to:
Slower long-term price growth for commodities.
Technological advancements reducing commodity usage.
Higher income elasticity of demand for manufactured goods.
As a result, many developing countries experience structural disadvantages in trade and seek export diversification.
Volatility and vulnerability
ToT is subject to significant volatility, particularly for commodity exporters. Fluctuations in global markets can cause unpredictable swings in national income and public revenue.
To manage these risks, countries may adopt:
Sovereign wealth funds to save windfall profits during favourable periods.
Exchange rate management to smooth price fluctuations.
Export diversification strategies to reduce reliance on a narrow set of products.
Understanding terms of trade and their fluctuations is essential for effective economic planning, trade policy formulation, and macroeconomic stability.
FAQ
Developed countries typically export high-value manufactured goods and services, whereas developing countries often export low-value primary commodities. This difference significantly impacts their respective terms of trade. Developed nations tend to experience more stable or improving terms of trade because manufactured goods generally have higher income elasticity of demand and benefit from technological innovation. In contrast, developing countries face volatile and often deteriorating terms of trade due to fluctuating global commodity prices, weak bargaining power, and inelastic demand for their exports. Moreover, over time, the prices of manufactured goods tend to rise relative to primary goods—a trend highlighted by the Prebisch-Singer hypothesis. This persistent decline in the relative value of exports for developing countries reduces their ability to purchase imports, constrains development funding, and makes them more vulnerable to external shocks. Consequently, terms of trade inequality is a critical issue in global economic development and trade relations.
Yes, a country can increase its export volumes while experiencing a deterioration in its terms of trade if export prices are falling faster than the growth in quantity exported. This typically occurs when the country is a price taker in global markets and faces inelastic or competitive demand for its goods. For instance, if global commodity prices fall and a country responds by exporting more to maintain revenue, the increased supply may further depress prices, worsening the terms of trade. Additionally, if the country’s exports are relatively price inelastic, revenue gains may be limited despite higher volumes. In such a scenario, the export price index falls relative to the import price index, leading to a decline in terms of trade. This outcome may reduce the country's real purchasing power even if total export revenue increases slightly, as it must sell more goods to afford the same value of imports. This is a common challenge in primary-exporting economies.
Deteriorating terms of trade can worsen income inequality within a country, particularly when certain regions or industries are disproportionately affected. If the export sector, such as agriculture or mining, sees falling prices and revenues, workers in those industries may experience wage stagnation or job losses. In contrast, sectors less exposed to international trade or more reliant on domestic demand may remain stable or even benefit if import prices rise and domestic substitutes are favoured. Additionally, poorer households may suffer more if deteriorating ToT leads to higher prices for essential imported goods like food and fuel. These groups typically spend a larger share of their income on basic necessities and are less able to absorb price shocks. In rural or export-dependent regions, lower earnings reduce consumption and investment, further entrenching regional disparities. Therefore, a sustained deterioration in terms of trade can exacerbate structural inequality, especially in economies with limited social safety nets or weak diversification.
Governments can employ a range of strategies to mitigate the adverse effects of volatile terms of trade. First, export diversification is critical. By reducing dependence on a narrow range of exports—particularly commodities—countries can stabilise revenue and reduce exposure to global price swings. Second, establishing sovereign wealth funds allows governments to save surplus revenues during periods of favourable terms of trade, which can be used to support the economy during downturns. Third, trade agreements and partnerships can provide stable markets and reduce reliance on unpredictable global spot markets. Fourth, investment in domestic value addition—such as processing raw materials into higher-value goods—can increase export prices and improve the terms of trade. Finally, governments can implement macroeconomic tools such as managing exchange rates, adjusting fiscal policy, and improving competitiveness to respond more flexibly to external shocks. A coordinated approach combining structural reforms and stabilisation policies is essential to buffer against ToT volatility.
An improvement in the terms of trade does not always translate into higher economic growth due to several offsetting factors. Firstly, if the improvement results from a rise in export prices due to domestic inflation or currency appreciation, this may reduce the competitiveness of exports in global markets, leading to a decline in export volumes. Secondly, improved ToT might cause complacency in policy-making, discouraging necessary structural reforms or investment in diversification. Thirdly, in economies with low export elasticity, the benefits of higher prices may not be widely distributed, limiting broader economic gains. Moreover, if higher export prices are not accompanied by productivity growth, they may create temporary windfalls without sustained output increases. Also, improvements in ToT driven by volatile commodities can reverse quickly, making growth unsustainable. In some cases, appreciation of the domestic currency due to better ToT may cause a Dutch disease effect, damaging other sectors like manufacturing. Therefore, improved ToT must be supported by sound economic policy to drive long-term growth.
Practice Questions
Explain two factors that may cause a country's terms of trade to deteriorate.
A country’s terms of trade may deteriorate due to falling export prices, especially if it relies heavily on primary commodities. A global oversupply or reduced demand can lower these prices, reducing the export price index relative to imports. Secondly, a depreciation of the domestic currency makes imports more expensive, raising the import price index. If export prices do not rise proportionately, the ratio of export to import prices falls. This results in the country needing to export more to afford the same quantity of imports, worsening the terms of trade and potentially reducing national purchasing power.
Evaluate the impact of an improvement in the terms of trade on an economy.
An improvement in the terms of trade enables a country to purchase more imports for a given quantity of exports, increasing real income and potentially improving living standards. Consumers may benefit from cheaper imported goods, reducing inflation. However, higher export prices can reduce competitiveness, potentially lowering export volumes and leading to trade imbalances. If demand for exports is price elastic, total revenue may fall. Moreover, sectors reliant on external demand may face contraction. Therefore, the overall impact depends on factors like the price elasticity of exports and the structure of the economy, especially its dependence on trade.
