Terms of Trade
Introduction to Terms of Trade
What is Terms of Trade?
The terms of trade measure the ratio of a basket of export prices to a basket of import prices. The terms of trade are used to measure the import purchasing power of exports. The basket of export prices and import prices are weighted according to their importance to trade flows. Terms of trade are linked with standards of living. An improved term of trade means that more imports can be bought with a given amount of exports, increasing consumption and hence standards of living. In other words, the more imports you can buy per dollar of exports, the richer you'll be (in economic terms).
What are the terms of trade outcomes?
There are two outcomes for terms of trade, either favourable or unfavourable. These refer to the changes in terms of trade between two periods.
Favourable suggests that the terms of trade has improved and that the import purchasing power of exports has increased, due to:
An increase in export prices greater than an increase in import prices; or
A fall in import prices greater than a fall in export prices.
Unfavourable suggests that the terms of trade have worsened and that the import purchasing power of exports has decreased, due to:
An increase in import prices greater than an increase in export prices; or
A fall in export prices greater than a fall in import prices.
What's the Formula for Terms of Trade?
The terms of trade formula is provided above, which is a ratio of the export price index to import price index and hence, is simply the export price index divided by the import price index, multiplied by 100.
For example, if you exported an Apple at $2, and imported bananas at $1, then your terms of trade would be 200 basis points, i.e. a ratio of one apple can buy two bananas.