The Terms of Trade (ToT) is the ratio of a country's average export prices to its average import prices, expressed as an index. It indicates the volume of imports a country can obtain per unit of exports.

• Improvement (Favourable Movement): If the ToT index rises (i.e., Px​ rises faster than Pm​, or Px​ falls slower than Pm​, or Px​ rises and Pm​ falls). This means the country can buy more imports for a given volume of exports.

• Deterioration (Unfavourable Movement): If the ToT index falls (i.e., Px​ falls faster than Pm​, or Px​ rises slower than Pm​, or Px​ falls and Pm​ rises). This means the country must sell more exports to buy the same volume of imports.

For example:

If the Index of Export Prices rises from 100 to 115 (+15%) and the Index of Import Prices rises from 100 to 110 (+10%):

The ToT has improved (104.5 > 100), as the country's export prices have risen by a greater percentage than its import prices.

Factors Influencing a Country's Terms of Trade

The Terms of Trade are influenced by anything that affects a country's export prices (Px​) or import prices (Pm​).

1. Changes in Global Demand and Supply

• Global Commodity Prices:

  • A rise in the global price of a major primary commodity export (e.g., oil, copper, agricultural goods) will increase Px​ and generally improve the ToT for the exporting country.

  • A rise in the global price of a major imported commodity will increase Pm​ and generally worsen the ToT for the importing country.

• Reciprocal Demand (Elasticity): If the demand for a country's exports is inelastic relative to the demand for its imports, the country can raise its Px​ (or resist a fall) without a significant drop in volume, leading to an improved ToT.

2. Economic Conditions and Productivity

• Inflation Rates:

  • If a country's domestic inflation is higher than its trading partners', its Px​ may rise faster than its Pm​, leading to a short-run improvement in ToT. However, this may be unsustainable as it reduces the international competitiveness of exports.

• Productivity and Technology:

  • A significant rise in productivity in a country's export industries can lower production costs. This may lead to a fall in Px​ to maintain competitiveness, which worsens the ToT. However, the country benefits from the ability to export a greater volume.

• Economic Growth:

  • Rapid economic growth may increase demand for imported goods, causing a rise in Pm​ (due to higher global demand or increased domestic demand for foreign currency), leading to a deterioration in ToT.

3. Exchange Rate Movements

• Currency Appreciation: An appreciation of the domestic currency makes imports cheaper (Pm​ falls) and exports more expensive in foreign currency terms (Px​ effectively rises). This typically leads to an improvement in the ToT.

• Currency Depreciation: A depreciation makes imports more expensive (Pm​ rises) and exports cheaper (Px​ effectively falls). This typically leads to a deterioration in the ToT.

4. Trade Policy and Structure

• Protectionism (e.g., Tariffs): Imposing a tariff on imports can reduce the volume demanded, potentially forcing foreign exporters to lower their prices, thus lowering Pm​ and improving the imposing country's ToT (assuming no retaliation).

• Trade Structure: The Prebisch-Singer Hypothesis suggests that the ToT for countries exporting primary products will tend to deteriorate over the long run relative to countries exporting manufactured goods, due to differing income elasticities of demand and productivity gains.

Impact of Changes in a Country's Terms of Trade

The impact of changes in a country's Terms of Trade (ToT) is complex and depends significantly on the causes of the change and the Price Elasticity of Demand (PED) for its exports and imports.

1. Impact of an Improvement in Terms of Trade (ToT↑)

An improvement means that the Index of Export Prices (Px​) has risen relative to the Index of Import Prices (Pm​). The country can now buy more imports for a given quantity of exports.

• Impact on Living Standards and Welfare:

  • Positive: An improved ToT increases the country's real income because imports are cheaper relative to the goods it sells abroad. The country can consume a greater volume of goods and services, directly improving material living standards and welfare.

  • Benefit of Cheaper Imports: Cheaper imports of capital goods or intermediate inputs (e.g., machinery, oil, raw materials) can reduce domestic production costs, leading to lower prices for consumers and potentially increasing long-run aggregate supply (LRAS).

• Impact on Inflation:

  • Positive (Reduced Cost-Push): Cheaper imports (Pm​↓) directly reduce the cost of imported raw materials and finished goods, helping to reduce cost-push inflationary pressure domestically.

• Impact on the Current Account Balance (BoP):

  • Ambiguous/Negative: The relative rise in export prices means the country's exports are now less competitive, and its imports are relatively cheaper. This is likely to lead to a fall in the volume of exports and a rise in the volume of imports.

  • The overall impact on the value of the current account depends on PED:

    • If the demand for exports is elastic (PEDx​>1), the price rise will cause total export revenue to fall, worsening the current account.

    • If the demand for imports is elastic (PEDm​>1), the price fall will cause total import expenditure to rise, worsening the current account.

    • Thus, an improvement in ToT often leads to a deterioration in the trade balance.

2. Impact of a Deterioration in Terms of Trade (ToT↓)

A deterioration means the Index of Export Prices (Px​) has fallen relative to the Index of Import Prices (Pm​). The country must now sell more exports to buy a given quantity of imports.

• Impact on Living Standards and Welfare:

  • Negative: A deteriorated ToT means the country's real income and purchasing power have been reduced. It takes more export effort to finance the same volume of imports, leading to a fall in material living standards.

• Impact on Inflation:

  • Negative (Increased Cost-Push): More expensive imports (Pm​↑), particularly of raw materials or oil, will increase the cost of production for domestic firms, leading to an increase in cost-push inflation.

• Impact on the Current Account Balance (BoP) and Economic Growth:

  • Ambiguous/Positive: The relative fall in export prices means the country's exports are now more competitive, and imports are relatively more expensive. This is likely to lead to a rise in the volume of exports and a fall in the volume of imports.

  • The overall impact on the value of the current account depends on PED:

    • If the Marshall-Lerner Condition (MLC) holds (PEDx​+PEDm​>1), the increase in export volume and decrease in import volume will be large enough to offset the price changes, leading to an improvement in the trade balance.

  • Export-Led Growth: The rise in export volumes due to lower prices can stimulate domestic production, leading to higher output, employment, and export-led economic growth. This is often seen as the primary benefit of a deterioration caused by increased productivity.

The Long-Run Deterioration for Developing Countries

The Prebisch-Singer Hypothesis suggests that the ToT for countries that are heavily reliant on primary commodity exports (Developing Economies) will tend to deteriorate in the long run relative to countries that export manufactured goods (Developed Economies).

• This is because the income elasticity of demand (YED) for manufactured goods is higher than for commodities, and the price of manufactured goods tends to rise more over time. This structural deterioration can make it extremely difficult for developing economies to finance their imports and pay off foreign debt.