The Terms of Trade
- Terms of trade refer to the ratio of a country’s average price of exports to the country’s average price of imports
- The relative price of imports & exports can have a direct bearing on the standard of living within a country
- Exporting goods which are highly priced results in higher incomes & the ability to buy cheaper imports
- The terms of trade capture the relationship between the average prices of a country's exports & imports
Calculation of The Terms of Trade
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- The index for exports & imports is created in much the same way that a consumer price index is created (using a weighted basket of imports & exports)
Worked example
Calculate the terms of trade for Country X. State if the terms of trade have improved or worsened. In the final column explain what that means for country X
Year | Index of average export prices | Index of average import prices | Calculation of terms of trade | Terms of trade | Improvement or deterioration? | Explanation |
2012 | 100 | 100 | ||||
2013 | 100 | 107 | ||||
2014 | 112 | 108 | ||||
2015 | 115 | 110 |
Step 1: Identify the index year as this is the base year & complete calculations for the index year
The index year will be the year in which both the index for export & import prices is 100
Year | Index of average export prices | Index of average import prices | Calculation of terms of trade | Terms of trade | Improvement or deterioration? | Explanation |
2012 | 100 | 100 | 100 | Base year | Both export & import index = 100 | |
2013 | 100 | 107 | ||||
2014 | 112 | 107 | ||||
2015 | 115 | 110 |
Step 2: Calculate the terms of trade for each year & state if they have improved/deteriorated
Year | Index of average export prices | Index of average import prices | Calculation of terms of trade | Terms of trade | Improvement or deterioration? | Explanation |
2012 | 100 | 100 | 100 | Base year | Both export & import index = 100 | |
2013 | 100 | 107 | 93.45 | Deterioration | ||
2014 | 112 | 107 | 104.67 | Improvement | ||
2015 | 115 | 110 | 104.55 | Deterioration |
Step 3: Explain what the improvement or deterioration means (explanation)
Year | Index of average export prices | Index of average import prices | Calculation of terms of trade | Terms of trade | Improvement or deterioration? | Explanation |
2012 | 100 | 100 | 100 | Base year | Both export & import index = 100 | |
2013 | 100 | 107 | 93.45 | Deterioration | One unit of exports buys fewer imports compared to the previous year | |
2014 | 112 | 107 | 104.67 | Improvement | One unit of exports buys more imports compared to the previous year | |
2015 | 115 | 110 | 104.55 | Deterioration | One unit of exports buys fewer imports compared to the previous year |
Factors Influencing a Country's Terms of Trade
- Relative inflation rates: Inflation increases the price of goods/services within a country. This means that their price is now more expensive to the rest of the world. If the exports are price inelastic in demand this will improve the terms of trade, if elastic then it is likely to worsen the terms of trade
- Relative productivity rates: continuous improvements in productivity can lower costs & these can be passed on in the form of lower prices. Lower prices for export products will mean that the terms of trade will deteriorate i.e. fewer imports can be bought with one unit of exports
- Changes in exchange rates: exchange rates constantly change the price of exports & imports. If prices change then the terms of trade between the two countries change. Specific data would need to be provided in order to determine if the terms of trade have improved or deteriorated for each trading partner