Terms of trade refers to the relative price of exports in terms of imports and
is defined as the ratio of export prices to import prices. It can be interpreted
as the amount of import goods an economy can purchase per unit of export goods.
An improvement of a nation's terms of trade benefits that country in the sense
that it can buy more imports for any given level of exports. The terms of
trade may be influenced by the exchange rate because a rise in the value of a
country's currency lowers the domestic prices of its imports but may not
directly affect the prices of the commodities it exports.
History The term terms of trade was first coined
by the US American economist Frank William Taussig in his 1927 book
International Trade. However, an earlier version of the concept can be traced
back to the English economist Robert Torrens and his book The Budget: On
Commercial and Colonial Policy, published in 1844, as well as to John
Stuart Mill's essay Of the Laws of Interchange between Nations; and the
Distribution of Gains of Commerce among the Countries of the Commercial World,
published in the same year, though allegedly already written in 1829/30.
Definition Terms of trade is a measure of how much
imports an economy can get for a unit of export goods. For example, if an economy
is only exporting apples and only importing oranges, then the terms of
trade are simply the price of apples over the price of oranges. In other
words, how many oranges can you get for a unit of apples. Since economies
typically export and import many goods, measuring the TOT requires defining
price indices for exported and imported goods and comparing the two.
A rise in the prices of exported goods in international markets would increase
the TOT, while a rise in the prices of imported goods would decrease it. For
example, countries that export oil will see an increase in their TOT when oil
prices go up, while the TOT of countries that import oil would decrease.
Two country model CIE economics In the simplified case of two countries
and two commodities, terms of trade is defined as the ratio of the total export
revenue a country receives for its export commodity to the total import
revenue it pays for its import commodity. In this case the imports of
one country are the exports of the other country. For example, if a country
exports 50 dollars' worth of product in exchange for 100 dollars' worth of
imported product, that country's terms of trade are 50/100 = 0.5. The terms of
trade for the other country must be the reciprocal. When this number is falling,
the country is said to have "deteriorating terms of trade". If
multiplied by 100, these calculations can be expressed as a percentage. If a
country's terms of trade fall from say 100% to 70%, it has experienced a 30%
deterioration in its terms of trade. When doing longitudinal calculations, it
is common to set a value for the base year to make interpretation of the
results easier. In basic Microeconomics, the terms of
trade are usually set in the interval between the opportunity costs for the
production of a given good of two countries.
Terms of trade is the ratio of a country's export price index to its
import price index, multiplied by 100. The terms of trade measures the rate of
exchange of one good or service for another when two countries trade with
each other. Multi-commodity multi-country model
In the more realistic case of many products exchanged between many
countries, terms of trade can be calculated using a Laspeyres index. In
this case, a nation's terms of trade is the ratio of the Laspeyre price index of
exports to the Laspeyre price index of imports. The Laspeyre export index is
the current value of the base period exports divided by the base period value
of the base period exports. Similarly, the Laspeyres import index is the
current value of the base period imports divided by the base period value of the
base period imports. Where
price of exports in the current period quantity of exports in the base period
price of exports in the base period price of imports in the current period
quantity of imports in the base period price of imports in the base period
Basically: Export Price Over Import price times 100 If the percentage is
over 100% then your economy is doing well. If the percentage is under 100%
then your economy is not going well. Limitations
Terms of trade should not be used as synonymous with social welfare, or even
Pareto economic welfare. Terms of trade calculations do not tell us about the
volume of the countries' exports, only relative changes between countries. To
understand how a country's social utility changes, it is necessary to
consider changes in the volume of trade, changes in productivity and resource
allocation, and changes in capital flows.
The price of exports from a country can be heavily influenced by the value of
its currency, which can in turn be heavily influenced by the interest rate
in that country. If the value of currency of a particular country is
increased due to an increase in interest rate one can expect the terms of trade
to improve. However, this may not necessarily mean an improved standard of
living for the country since an increase in the price of exports perceived by
other nations will result in a lower volume of exports. As a result,
exporters in the country may actually be struggling to sell their goods in the
international market even though they are enjoying a high price.
In the real world of over 200 nations trading hundreds of thousands of
products, terms of trade calculations can get very complex. Thus, the
possibility of errors is significant. References
^ Obstfeld, M., Rogoff, K.. Foundations of International Macroeconomics.
Cambridge, MA: MIT Press. Page 199. ^ Reinsdorf, M.B.. Terms of Trade
Effects: Theory and Measurement. Bureau of Economic Analysis. Page 1.
^ Marshall, Reinsdorf. "Terms of Trade Effects: Theory and Measurement".
working paper. BEA. Retrieved October 2009.
See also Singer–Prebisch thesis about the
tendency to deterioration of the terms of trade between primary products and
manufactured goods.