Terms of Trade

Economics: Edexcel A A Level, topic 7.1.6

Terms of trade describe the price of a nation's exports relative to the price of a nation's imports.

A nation's Terms of Trade = (Average export price index ÷ Average import price) X 100.
A nation's terms of trade have improved if they can buy more imports for a given amount of exports.
Brazil exports oil. When the oil price is very high, Brazil can buy more consumer goods and machinery (capital goods) with a given amount of oil exported because the value of their export index rises.
If an increase in import prices is larger than an increase in export prices, then a nation's terms of trade have worsened.

Anything affecting exports and imports will affect terms of trade.
A technological advance in the nation will allow it to export either higher quality goods (worth more money) or export higher volumes of goods.
A tariff imposed by another nation will automatically worsen a nation's terms of trade.
A commodity price boom could improve a commodity exporter's terms of trade and worsen a commodity importer's terms of trade.
An increase in the value of a nation's currency will lower the price of imports in the country, improving terms of trade.

Worsening terms of trade will mean that a nation can afford to import a lower value of goods from abroad.
If the nation continues to import as they did before, their current account deficit will get worse.
A nation's domestic industry may become more price competitive relative to imported goods and this may increase tax revenues for the government.
Worsening terms of trade may cause cost-push inflation as either more expensive domestic goods have to be purchased or more expensive imports still have to be bought.

Test yourself on Terms of Trade

What happens to a nation's terms of trade if an increase in import prices is larger than an increase in export prices?