The terms of trade
A country's terms of trade refer to the relative price of exports and imports.
The formula to work out the terms of trade is:
|
Index of export prices Index of import prices |
x | 100 | = | Terms of trade |
|---|
For example, if export prices rise by 8% in a given year, and import prices rise by 5%, the terms of trade are:
|
108 105 |
x | 100 | = | 102.86 |
|---|
Here, the term of trade have improved by 2.86%.
Improving terms of trade
If a country’s terms of trade improve, it means that for every unit of exports sold a country can purchase more units of imports.
An increase in the terms of trade creates a benefit in respect of how many goods need to be exported to buy a given amount of imports. This can increase standards of living in the future.
However, improving terms of trade can also worsen the balance of payments, as imports may increase relative to exports.
Worsening terms of trade
If terms of trade worsen a country has to export more to purchase a given quantity of imports.
Generally, the global trend for terms of trade is that countries that export commodities and low value manufactured goods have suffered a worsening terms of trade, while those exporting high valued manufactured goods and services have experienced an improving terms of trade.
This has meant that developing countries have to produce and export increasingly more of their commodities to be able to import from industrialised developed economies. This is supported by the Prebisch-Singer hypothesis, which points to differential income elasticity of demand for consumer goods compared with commodities.
As global incomes have increases, demand for some commodities has fallen relative to demand for consumer goods.
However, the effect of globalisation may have been to benefit of some developing countries, or at least as prevented the gap between the developed and developing world widening further.