Terms of trade

A country’s terms of trade measures a country’s export prices in relation to its import prices, and is expressed as:

Terms of trade image

For example, if, over a given period, the index of export prices rises by 10% and the index of import prices rises by 5%, the terms of trade are:

110  x 100 / 105

= 104.8

This means that the terms of trade have improved by 4.8%.

When the terms of trade rise above 100 they are said to be improving and when they fall below 100 they are said to be worsening.

The terms of trade can also be expressed in terms of the number 1, with figures above 1 indicating an improvement, and those below 1 a worsening. This is shown in the chart below.

Improving terms of trade

If a country’s terms of trade improve, it means that for every unit of exports sold it can buy more units of imported goods. So potentially, a rise in the terms of trade creates a benefit in terms of how many goods need to be exported to buy a given amount of imports. It can also have a beneficial effect on domestic cost-push inflation as an improvement indicates falling import prices relative to export prices.

However, countries may suffer in terms of falling export volumes and a worsening balance of payments.

Terms of trade