Y13 - Terms of Trade (important for development)

Terms of Trade

The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each other.

For international trade to be mutually beneficial for each country, the terms of trade must lie within the opportunity cost ratios for both country.

We calculate the terms of trade as an index number using the following formula:

Terms of Trade Index = (Average export price index / Average import price index) * 100

If export prices are rising faster than import prices, the terms of trade index will rise. This means that fewer exports have to be given up in exchange for a given volume of imports.

If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services.

The terms of trade fluctuate in line with changes in export and import prices. Clearly the exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade.

OIL PRICES AND THE TERMS OF TRADE

Many developing countries are heavily dependent on exporting oil. And volatility in international commodity markets create serious problems with these countries’ terms of trade. In the chart below, notice how closely the annual % change in the terms of trade follows the movement in oil export prices.

When oil values collapsed in 1998, developing countries faced the enormous problem of having to export much more oil to pay for a given volume of imports. The worsening in the terms of trade will have adversely affected living standards in these countries. There has been a sharp rebound in global oil prices this year, helping to boost the terms of trade for oil exporters.

TERMS OF TRADE FOR DEVELOPING NATIONS

Developing countries can be caught in a trap where average price levels for their main exports decline in the long run. This depressed the real value of their exports and worsens the terms of trade. A greater volume of exports have to be given up to finance essential imports of raw materials, components and fixed capital goods.

The problems intensified in 1998 with the collapse in the currencies of many Asian developing countries. A big fall in the terms of trade signifies a reduction in real living standards since imports of goods and services have become relatively more expensive.

TERMS OF TRADE AND COMPETITIVENESS

Consider the effects of a large fall in the value of the exchange rate. The effect should be a fall in export prices and a rise in the cost of imports. This worsen the terms of trade index. But the lower exchange rate restores competitiveness for a country since demand for exports should grow and import demand from domestic consumers should slow down.

Much depends on how producers respond to the lower exchange rate. And for countries without a diversified industrial base, the decline in earnings from each unit of exports has a damaging effect on output, investment and employment.