Friday, October 26, 2007

What is the Terms of Trade

Readers Question: What is the terms of trade?

The Terms of Trade measures the relative price of exports compared to the price of imports.

Terms of Trade = 100 * Average export prices / Average Import prices

Basically, the terms of trade refers to how many exports will need to be sold in order to be able to purchase imports.

  • If the price of exports increases, there will be an improvement in the terms of trade.
  • If the price of exports falls, there will be a decline in the terms of trade.

If a country like Cuba, relies on the export of sugar, their terms of trade will depend a lot on the price of sugar. If there is a fall in the price of sugar, Cuba will experience a deterioration in the terms of trade.

Fall in the exchange Rate.

If there is a fall in the exchange rate, there will be a deterioration in the terms of trade because the price of exports falls.
For example, the devaluation of the dollar has worsened the US terms of Trade.

What is the Importance of the Terms of Trade?

To some extent we can use the terms of trade to measure the strength and well being of an economy. A prolonged fall in the terms of trade will reduce living standards. The US, will find that it can increasingly purchase less imports from abroad. But, at the same time it is also quite limited. For example, a devaluation doesn’t necessarily harm a country. A devaluation does make exports more competitive and can increase economic growth.

There is much more to the strength of an economy than the terms of trade. For example:
  • Volumes of trade
  • productivity
  • capital flows
  • economic growth

See also: Measuring international competitiveness

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