Terms of Trade
How to Calculate Terms of Trade
David Ricardo’s theory of comparative advantage explains that if countries specialize in the
production of the goods/service in which they have comparative advantage in, then all
countries can move outside their PPF and gain from trade.
Terms of trade can be calculated:
Terms of trade index (ToT) = 100 x Average export price index / Average import price index.
Factors Affecting Terms of Trade
Short term:
- Exchange rate: A change in exchange rate will affect import and export prices. Rising
exchange rate likely to improve terms of trade.
- Inflation in trading partners: A rise in inflation in trading partners means that your
exports are more price competitive, so your terms of trade are likely to improve.
- Changes in demand for imports/exports.
Long term:
- Rise in productivity: This will reduce relative price of exports as higher productivity
leads to lower costs of production. Increase in terms of trade in the country where
production rises.
- Changing incomes: As world incomes rise, things such as tourism demand rises. Rise
in prices in the tourism industry.
- Primary product dependency: Some countries rely on certain commodities such as oil
or copper, so their terms of trade will be influenced by fluctuating prices.
Effect of Changes in the Terms of Trade on the Balance of Payments
Exports are price elastic: A rise in export prices will lead to a larger fall in export quantity.
Therefore, an increase in price will lead to an increase in the terms of trade but a deterioration
in the balance of payments.
Exports are price inelastic: A rise in export prices will improve the terms of trade and the
balance of payments as value of exports rise because a rise in price leads to a proportionally
less decrease in volume.
Imports are price elastic: A rise in import prices will cause deterioration in the terms of trade
but improve the balance of payments as the value of imports falls because a rise in prices
leads to a proportionally higher decrease in demand.
Imports are price inelastic: A rise in import prices then the terms of trade will deteriorate, and
the balance of payments falls because a rise in prices leads to a proportionally smaller
decrease in volume, so the value of imports rise.
How to Calculate Terms of Trade
David Ricardo’s theory of comparative advantage explains that if countries specialize in the
production of the goods/service in which they have comparative advantage in, then all
countries can move outside their PPF and gain from trade.
Terms of trade can be calculated:
Terms of trade index (ToT) = 100 x Average export price index / Average import price index.
Factors Affecting Terms of Trade
Short term:
- Exchange rate: A change in exchange rate will affect import and export prices. Rising
exchange rate likely to improve terms of trade.
- Inflation in trading partners: A rise in inflation in trading partners means that your
exports are more price competitive, so your terms of trade are likely to improve.
- Changes in demand for imports/exports.
Long term:
- Rise in productivity: This will reduce relative price of exports as higher productivity
leads to lower costs of production. Increase in terms of trade in the country where
production rises.
- Changing incomes: As world incomes rise, things such as tourism demand rises. Rise
in prices in the tourism industry.
- Primary product dependency: Some countries rely on certain commodities such as oil
or copper, so their terms of trade will be influenced by fluctuating prices.
Effect of Changes in the Terms of Trade on the Balance of Payments
Exports are price elastic: A rise in export prices will lead to a larger fall in export quantity.
Therefore, an increase in price will lead to an increase in the terms of trade but a deterioration
in the balance of payments.
Exports are price inelastic: A rise in export prices will improve the terms of trade and the
balance of payments as value of exports rise because a rise in price leads to a proportionally
less decrease in volume.
Imports are price elastic: A rise in import prices will cause deterioration in the terms of trade
but improve the balance of payments as the value of imports falls because a rise in prices
leads to a proportionally higher decrease in demand.
Imports are price inelastic: A rise in import prices then the terms of trade will deteriorate, and
the balance of payments falls because a rise in prices leads to a proportionally smaller
decrease in volume, so the value of imports rise.
