Terms of Trade

Definitions

The terms of trade measures how the prices of a country’s export prices are changing compared to its import prices.

Factors Influencing a Country’s Terms of Trade

Change in the exchange rate – If a country’s exchange rate appreciates (goes up in value against other currencies), this will increase the prices of its exports and reduce import prices, resulting in an improvement in the terms of trade. A depreciation in the exchange rate will have the opposite effect. (see notes on 4.1.8)

Change in the relative rate of inflation – If a country has the same rate of inflation as its trading partners, the prices of its exports are likely to change at the same rate as the prices of its imports, leaving the terms of trade unchanged. But if its domestic inflation accelerates relative to its trading partners, its export prices will rise faster than its import prices, causing the terms of trade to improve (and vice versa if its relative inflation rate falls).

Changes in demand or supply for imports or exports – The prices of goods and services that are internationally traded depend on global patterns of demand and supply. For example oil exporting countries have experienced big changes in their terms of trade resulting from rises or falls in oil prices. The price of oil fell from $140 to $40 per barrel after the global financial crisis. This was largely due to the fall in demand as many countries went into a severe recession. Subsequently, demand for oil has recovered along with the global economy, pushing prices back up again.

In general, the prices of commodities (primary products), including oil are more volatile than those of manufactured goods and services, because both demand and supply tend to be relatively price inelastic (see notes on 1.2.3 and also below). Countries that depend heavily on primary products therefore tend to experience greater luctuations in their terms of trade.

Changes in relative productivity – If a country has a faster rate of productivity growth than its trading partners, it is likely to have falling costs of production and its exports will fall in price relative to imports, resulting in a worsening terms of trade.

Calculation of the Terms of Trade

The terms of trade is calculated using weighted index numbers. The method is very similar to the one used to calculate the consumer prices index (see notes on 2.1.2).

A base year is selected as the starting point. In the base year the prices of exports and imports are recorded. The indices of both exports and imports in the base year are assigned values of 100.

In the following years prices of exports and imports are recorded using a system of weights to reflect the relative importance of different goods and services. For instance, the U.K. imports both wine and cranberry juice, but the value of wine imports far exceeds that of cranberry juice, so wine has a much greater weight.

Let us suppose that the weighted indices for a country’s import and export prices are as follows:

	Base Year (0)	Year 1	Year 2	Year 3
Index of Export Prices	100	105	110	112
Index of Import Prices	100	102	104	110

The terms of trade index (TTI) can now be calculated using the formula below as follows:

TTI = (Index of Export Prices / Index of Import Prices) x 100

The TTI in Year 1 is therefore (105/102) X 100 = 102.9 (to one decimal place)

The TTI in Year 2 is (110/104) X 100 = 105.8

In Year 3 it is (112/110) X 100 = 101.8

In years 1 and 2 the TTI increased in value. This is called an improvement in the terms of trade. It means that a country’s exports increased in price relative to its imports.

In year 3 the TTI fell. This is a worsening of the terms of trade. Imports increased in price relative to exports.

An improvement in the TTI can result from any of the following changes:

Export Prices:	Rise	No change	Rise faster	Rise	Fall
Import Prices:	Fall	Fall	Rise	No change	Fall faster

Corrspondingly, a worsening of the TTI can result from the following:

Import Prices:	Rise	No change	Rise faster	Rise	Fall
Export Prices:	Fall	Fall	Rise	No change	Fall faster

Note that it is possible for the index of export prices or import prices to fall below 100 (if prices of exports or imports fell below their level of the base year).

It is also possible for the TTI to fall below 100. This would mean that export prices had fallen relative to import prices compared to the base year. For instance, if the index of import prices had risen in Year 1 to 110 rather than 102, the Terms of Trade index would have been 95.5.

Impact of Changes in a Country’s Terms of Trade

Living standards - An improvement in the terms of trade means that a country can buy a greater quantity of imports for any given quantity of exports. In other words it has to sacrifice less of its output to pay for its imports. Other things being equal this means that an improvement in its terms of trade will lead to higher living standards. This is seen most spectacularly in the case of some of the oil producers in the Middle East, whose economies were transformed by steadily rising oil prices in the second half of the 20th century. Some of these countries are now enjoying some of the highest per capita incomes in the world. A worsening terms of trade, by contrast is likely to mean a fall in living standards, as more of domestic output has to be exported to pay for imports.

Impact on the balance of payments – An improvement in the terms of trade may improve or worsen the country’s current account balance, depending on why the terms of trade have improved. If a country’s export prices have risen because of a strong growth in demand from its trading partners, it is likely that export earnings will increase and the current account may improve. But if export prices have risen because the country has increasing costs of production, it is likely that export earnings may fall, as the country’s exports become less competitive.

Equally, a worsening of a country’s terms of trade due to a fall in its export prices could improve the current account if prices have fallen due to an improvement in productivity, making exports more competitive. But a fall in export prices because of lower world demand is likely to lead to a deterioration in the current balance.

By the same reasoning, it should be understood that an improvement or worsening in the terms of trade due to changes in import prices can also result in either an improvement or worsening of the current account.

The price elasticity of demand (PED) for exports and imports is central to an understanding of the impact of a change in the terms of trade on the current account. If the combined PED of exports and imports is greater than 1, a worsening of the terms of trade will lead to an improvement in the current account. If the PED is less than 1 it will cause a worsening of the current account. The opposite applies if the terms of trade improve. (see notes on Marshall-Lerner condition in 4.1.8 for full explanation)

Impact on inflation – An improvement in the terms of trade because of falling import prices could result in lower inflation, both directly, because prices of imported goods have fallen but also indirectly, because domestic producers may have to lower prices to compete with imports. A worsening terms of trade could cause rising inflation. Workers may seek pay increases to compensate for rising import prices, leading to an escalation of the wage price ‘spiral’.

Impact on growth and employment – If the terms of trade improve because of growing demand for exports (leading to higher export prices), it is likely that growth and employment levels will be maintained, or possibly improved. But if the improvement is because of falling import prices or rising export prices due to rising costs, it is likely that growth and employment will fall.

Identify and explain the possible economic consequences of a worsening of a country's terms of trade.

Your answer should include: living standards / current account / balance of payments / price elasticity of demand / export prices / import prices / inflation / growth / employment