Terms of Trade
What is Terms of Trade?
Terms of trade refers to the relative price of imports in terms of exports and is defined as the ratio of export prices to import prices.
The terms of trade indicates how much a country can buy of the goods it doesn't produce domestically using one unit of goods it does produce. An improvement in a nation's terms of trade means it can buy more imports for a given level of exports, benefiting the country. Deteriorating terms of trade means a country must export more to finance the same level of imports.
Terms of Trade: a worked example
Suppose Country Anvara exports lumber and imports coffee. In the base period its export price index and its import price index both sit at 100, so terms of trade equal 100/100, which is 1.00 or an index of 100. Over the next period lumber prices push the export index to 126 while coffee prices push the import index to 105. New terms of trade equal 126/105 = 1.20, or 120. Anvara's terms of trade improved by 20 percent, so the same physical volume of lumber exports now finances 20 percent more coffee. Reverse the numbers, with the export index at 105 and the import index at 126, and the ratio becomes 105/126 = 0.833, a deterioration of 16.7 percent. Anvara must then ship out 20 percent more lumber to buy the same coffee it bought before.
The mistake students make with terms of trade
The most frequent error is flipping the ratio and dividing import prices by export prices. The textbook wording about the relative price of imports pulls students toward putting imports on top, and the flip reverses every conclusion, turning an improvement into a decline. Export prices always go in the numerator. A second error is treating better terms of trade as a bigger trade surplus. Terms of trade measure a price ratio, not volumes, so pricier exports can lift the ratio while foreign buyers cut back and the trade balance worsens.
Terms of Trade questions
What does an improvement in the terms of trade mean?
An improvement means export prices have risen relative to import prices, so each unit of exports buys more imports than before. If a country's export price index climbs from 100 to 115 while its import price index holds at 100, terms of trade rise from 1.00 to 1.15, and the country can finance 15 percent more imports with the same export volume. The gain shows up as higher purchasing power abroad, not automatically as a larger trade surplus.
What terms of trade will two countries accept when they specialize?
Acceptable terms of trade fall strictly between the two countries' opportunity costs. Say Anvara gives up 2 bushels of coffee per unit of lumber while Belora gives up 5 bushels per unit of lumber. Anvara holds the lower opportunity cost in lumber and will only export it for more than 2 bushels, while Belora will only import it for less than 5 bushels. Any rate between 2 and 5 bushels of coffee per unit of lumber leaves both countries better off.
Do terms of trade and the balance of trade measure the same thing?
Terms of trade and the balance of trade answer different questions. Terms of trade compare export prices with import prices and produce a ratio, showing purchasing power per unit shipped. The balance of trade compares total export value with total import value and produces a dollar figure, showing whether a country sells more than it buys. A country can post a trade deficit while its terms of trade improve, because a price ratio says nothing about the quantities traded.
Formula / Example
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Related terms
Common comparisons
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