Terms of Trade

An index greater than 100 indicates an improvement in the terms of trade, meaning that the country can import more for each unit of exports. Conversely, an index below 100 signifies a deterioration, where the country has to export more to afford the same volume of imports. A rising ToT can improve a country's standard of living, but its implications depend heavily on the causes and context of the change.

Interpreting the Terms of Trade

While a higher ToT implies that a country can purchase more imports for a given value of exports, this is not always a positive development. If export prices are rising because of improved demand or productivity, the country gains both in terms of income and competitiveness. However, if export prices are rising due to domestic inflation or rising production costs, the country may be becoming less competitive in international markets — even though its ToT has improved.

Similarly, a fall in the ToT is not automatically harmful. If import prices rise while export prices remain constant, purchasing power may fall, which can reduce living standards. However, if a fall in ToT is driven by a depreciation of the exchange rate, it may lead to increased price competitiveness of exports, potentially stimulating output and employment in the traded goods sector. Therefore, changes in ToT must be evaluated alongside changes in export and import volumes, price elasticities, and the underlying economic context.

Causes of Changes in Terms of Trade

Changes in a country’s terms of trade can be influenced by several demand- and supply-side factors, as well as external shocks and policy choices. One major influence is the relative global demand for a country’s exports and imports. For example, if there is strong growth in major trading partners, demand for exports may rise, increasing export prices and improving the ToT. Alternatively, if global commodity prices fall — reducing the cost of imports like oil — the ToT can improve, even without changes in export prices.

Another key factor is the exchange rate. An appreciation of the domestic currency makes imports cheaper and exports more expensive in foreign markets. This generally leads to an improvement in the ToT, although it may reduce the competitiveness of exports. In contrast, a depreciation will likely worsen the ToT but could support export-led growth if price elasticities are favourable.

Domestic inflation also plays a role. If a country experiences higher inflation than its trading partners, its exports become more expensive, potentially improving ToT in the short run. However, this improvement may come at the cost of declining external competitiveness. Additionally, trade protection policies, such as tariffs or quotas, can distort relative prices and therefore affect ToT, though often with secondary trade-offs in efficiency and retaliation. Lastly, countries heavily dependent on primary commodity exports — especially developing economies — often face volatile ToT due to the inherent instability of global commodity markets.

Impact of Terms of Trade Changes

The impact of a change in ToT depends on both the direction of the change and the structure of the economy in question. An improvement in the ToT implies that a country can buy more imports for the same quantity of exports. This may lead to higher real income, better access to foreign goods, and potentially an improved current account position, particularly if export volumes remain stable. For high-income countries with diversified exports, this can translate into enhanced living standards and domestic consumption.

However, the benefits of an improved ToT are not guaranteed. If export prices rise due to domestic inflation or currency appreciation, then although the ToT improves, exports may become less competitive, leading to falling export volumes and potential trade deficits. In this case, the long-term sustainability of the improved ToT is questionable.

On the other hand, a deterioration in the ToT implies that a country must export more to afford the same quantity of imports. This often leads to a fall in real income, particularly if the country relies heavily on essential imports such as energy or food. Developing countries, in particular, may experience reduced access to capital goods or intermediate inputs, slowing growth and development. However, if a falling ToT is caused by a currency depreciation, it may boost exports and reduce imports, thus improving the balance of payments — assuming demand is sufficiently responsive.

Elasticity and the Terms of Trade

Understanding the effects of ToT changes also requires an analysis of price elasticity of demand for exports and imports. When the demand for a country's exports is price inelastic, a rise in export prices can increase export revenue and thus improve the current account, in addition to the ToT. However, if demand is price elastic, higher prices may reduce total export revenue, even if the ToT improves.

This dynamic is captured by the Marshall–Lerner condition, which states that a depreciation (which worsens the ToT) will only improve the trade balance if the sum of the price elasticities of demand for exports and imports is greater than one. In the short term, demand tends to be inelastic, so depreciations may initially worsen the trade balance before improving it — a pattern known as the J-curve effect. Therefore, understanding how elasticities interact with ToT movements is crucial when assessing the macroeconomic consequences of external price shocks or currency changes.

Terms of Trade and Development

Terms of trade are particularly important for developing economies, many of which are heavily dependent on the export of primary commodities. These goods tend to have low and volatile prices, while the imports they rely on — such as manufactured goods, machinery, or pharmaceuticals — tend to rise in price over time. This can lead to a long-term deterioration in ToT, a phenomenon often referred to in development economics as the Prebisch–Singer hypothesis.

If this long-run deterioration occurs, it can lead to worsening trade balances, falling real incomes, and increased dependence on aid or borrowing. It also constrains the ability of these economies to fund capital investment and diversify their industrial base. As a result, many economists argue that developing countries need to diversify away from primary products to achieve more stable and favourable terms of trade in the long run.