Terms of trade

In international economics and international trade, terms of trade or TOT is (Price of exportable goods)/(Price of importable goods). In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports. "Terms of trade" are sometimes used as a proxy for the relative social welfare of a country, but this heuristic is technically questionable and should be used with extreme caution. An improvement in a nation's terms of trade (the increase of the ratio) is good for that country in the sense that it can buy more imports for any given level of exports. The terms of trade is influenced by the exchange rate because a rise in the value of a country's currency lowers the domestic prices for its imports but does not directly affect the commodities it produces (i.e. its exports).

Meaning

"Terms of Trade is the ratio of quantities of domestic goods that a country must give up to obtain a unit of imported goods."

Situations in which the T.O.T would rise or fall:

A rise in the prices of imported goods, with the prices of exports remaining unchanged indicates a fall in the terms of trade because it will now require more exports to import the same quantity of goods.

A rise in the prices of exported goods with the prices of imports unchanged indicate a rise in the terms of trade because it will now take fewer exports to purchase the same quantity of imports.

The term

"Terms of trade" takes a plural form. However, it is a single number that represents the ratio of the relative prices.

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 (100/50 = 2). 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 (50% and 200% respectively). If a country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced a 30% deterioration in its terms of trade. When doing longitudinal (time series) calculations, it is common to set a value for the base year^{[citation needed]} 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

The terms of trade of Australia since 1959. Note the effect of the resources boom from 2005.

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.

${{p_x^c\, q_x^0}\over{p_x^0\, q_x^0}} \left/ {{p_m^c\, q_m^0}\over{p_m^0\, q_m^0}}\right.$

Where

$p_x^c=$price of exports in the current period

$q_x^0=$ quantity of exports in the base period

$p_x^0=$ price of exports in the base period

$p_m^c=$ price of imports in the current period

$q_m^0=$ quantity of imports in the base period

$p_m^0=$ 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 (Capital Accumulation). If the percentage is under 100% then your economy is not going well (More money going out than coming in).

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 (supposedly) 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.

See also

• Singer–Prebisch thesis about the tendency to deterioration of the terms of trade between primary products and manufactured goods.