Terms of Trade – GED Explains

What does the concept of terms of trade (TOT) mean, and what does it tell us about a country’s international competitiveness?

The meaning of Terms of Trade

The Terms of Trade of one country indicate how many units of an imported good (or units of a bundle of imported goods) the country receives for one unit of its exported good (or one unit of a bundle of exported goods).

The TOT can also be viewed as the country’s real exchange ratio because they indicate how many imported goods the country receives for a given bundle of exported goods.

An improvement in the TOT means that the country can sell its products on the world market, receiving more import good units for one unit of its export good. Domestic products are thus deemed so attractive by consumers abroad that they are willing to pay an increasing price. This can be interpreted as an improvement in the country’s international competitiveness (competitive effect).

An improvement in the Terms of Trade also implies an increase in the material wealth of the population. The country receives an increasing quantity of imported goods for a given quantity of its export goods. This improves consumption and investment opportunities at home (wealth effect).

Terms of Trade Calculation

A country’s Terms of Trade are calculated by dividing the price index of its export goods by the price index of its import goods. The price index of imported goods is calculated by using the prices of the goods that the country buys in the rest of the world.

These prices are included in this index according to the weighting of the trading partners and the individual goods. The price index for goods and services sold abroad is calculated accordingly.

For comparisons over time, a base year is chosen. The two price indices are normalized to 100 for this year. This means that the TOT for this base year are also equal to 100. Let us assume that 2015 is taken as the base year. If the export prices have risen an average of say 2 percent over the next year, then the export price index rises to 102 for 2016.

If the value of the price index of imported goods does not change, the Terms of Trade increase by 2 percent. However, if the prices of imported goods have also increased by 2 percent on average, the TOT remain constant.