Syllabus points
- Define and calculate the terms of trade.
- Distinguish an improvement from a deterioration in the terms of trade.
- Explain the causes of changes in the terms of trade.
- Evaluate the consequences, including for commodity-dependent economies.
Definition and calculation
The terms of trade measure the rate at which a country's exports exchange for its imports:
Terms of trade = (index of export prices ÷ index of import prices) × 100
An improvement means the index rises: export prices rise relative to import prices, so a given volume of exports buys more imports. A deterioration means the index falls.
⚠️ An "improvement" is not automatically good news, and a "deterioration" is not automatically bad. The terms of trade measure prices, not volumes or export revenue — the welfare effect depends on elasticities.
Causes of change
| Cause | Effect on terms of trade |
|---|---|
| Rising global demand for a country's exports | Improvement (export prices rise) |
| Falling world commodity prices for an exporter | Deterioration |
| Appreciation of the currency | Improvement (export prices rise in foreign currency) |
| Higher domestic inflation than trading partners | Improvement in the index, but a loss of competitiveness |
| Productivity growth lowering export prices | Deterioration in the index, though competitiveness improves |
The last two rows are the ones examiners test: the index can move in the *opposite* direction to competitiveness.
Consequences — the role of elasticity
The effect on export revenue depends on price elasticity of demand (PED) for exports:
- If demand for exports is price inelastic, an improvement (higher export prices) raises total export revenue.
- If demand is price elastic, the same improvement causes a proportionately larger fall in quantity demanded, so export revenue falls.
An improvement also makes imports relatively cheaper, which can raise living standards and ease cost-push inflation.
Commodity-dependent economies
Many low-income economies export primary commodities and import manufactured goods. Two problems follow:
- Volatility: commodity prices swing sharply with supply shocks and global demand, making export earnings and government revenue unstable.
- The Prebisch–Singer hypothesis: over the long run, primary-product prices tend to fall relative to manufactured-goods prices, implying a persistent deterioration in the terms of trade for commodity exporters — a structural argument for diversification into higher value-added production.
Worked example
Export prices rise from an index of 100 to 110 while import prices rise from 100 to 105. The terms of trade = (110 ÷ 105) × 100 = 104.8 — an improvement of 4.8%. If demand for the country's exports is price elastic, however, export revenue may still fall despite the improved index.
Common exam mistakes
- Assuming an improvement in the terms of trade always benefits the economy.
- Confusing the terms of trade (a price ratio) with the balance of trade (a value difference).
- Ignoring elasticity when judging the effect on export revenue.
Exam technique
Calculate the index accurately, state whether it improved or deteriorated, then evaluate the revenue effect through PED and — for commodity exporters — volatility and Prebisch–Singer.
Quick revision
- ToT = (export price index ÷ import price index) × 100.
- Improvement = export prices up relative to import prices.
- Revenue effect depends on PED for exports.
- Commodity exporters: volatility + Prebisch–Singer long-run decline.