Measurement of the terms of trade

The terms of trade measure the ratio between a country's export prices and its import prices. This ratio shows how many imports a country can afford to buy using the revenue from its exports.

Calculating the terms of trade index

$\text{Terms of trade index}=\frac{\text{index of export prices}}{\text{index of import prices}}\times 100$

The index is based on average prices of traded items, adjusted for their relative importance in trade.

Interpreting changes in the terms of trade index

• Favourable movement (improvement) - An increase in the index, meaning fewer exports are needed to purchase the same quantity of imports.
• Unfavourable movement (deterioration) - A decrease in the index, meaning more exports must be sold to afford the same quantity of imports.

Worked example - Calculating the terms of trade index

In a given year, a country's index of export prices is 130, and its index of import prices is 110. Calculate the terms of trade index and interpret whether this represents a favourable or unfavourable movement compared to a base index of 100.

Step 1: Identify the values

• Index of export prices = 130
• Index of import prices = 110

Step 2: Apply the formula

$\text{Terms of trade index}=\frac{130}{110}\times 100=118.2$

Step 3: Interpretation

An index of 118.2 shows a favourable movement compared to 100, as export prices have risen more than import prices, allowing the country to buy more imports with the same export revenue.

Causes of changes in the terms of trade

Changes in the terms of trade occur when export prices move relative to import prices.

Factors leading to a favourable movement

A favourable movement happens when export prices rise relative to import prices.

This can occur when:

• Export prices rise more than import prices
• Import prices fall while export prices remain unchanged

Factors leading to an unfavourable movement

An unfavourable movement occurs when export prices fall relative to import prices.

This can occur when:

• Import prices fall less than export prices
• Import prices rise while export prices fall

Underlying causes of changes

Changes are caused by:

• Shifts in demand and supply of exports and imports
• Changes in price levels
• Exchange rate fluctuations

An increase in demand for exports would increase their price, causing a favourable movement. A rise in a country's relative inflation rate would make export prices higher relative to import prices. Reducing the exchange rate is sometimes referred to as deliberately deteriorating the terms of trade to increase international competitiveness.

The Prebisch-Singer hypothesis

The Prebisch-Singer hypothesis argues that terms of trade tend to move against countries that primarily produce primary products.

Key elements of the Prebisch-Singer hypothesis

• Income elasticity of demand - It is based on the view that when income increases, demand for manufactured goods and services rises more than demand for primary products.
• Recent trends - In recent years, some agricultural product prices have fallen, but commodity prices show more volatility.

Impact of changes in the terms of trade

The effects of changes in the terms of trade on a country's economy depend on the underlying causes and the price elasticity of demand for exports and imports.

Effects of a favourable movement

• If export prices increase due to rising demand, it's likely beneficial as more domestic products will be sold.
• If export prices increase due to rising production costs, demand for exports may fall and export revenue may decline.

Effects of an unfavourable movement

• An unfavourable movement may actually reduce a current account deficit if demand for exports and imports is elastic.
• The fall in export prices relative to import prices should increase export revenue relative to import expenditure when demand is elastic.