Terms of Trade

The terms of trade (ToT) are the ratio of the average price of a country's exports to the average price of its imports, usually expressed as an index. If a country's export prices rise faster than its import prices, its terms of trade improve: each container of goods it sells abroad pays for more goods bought from abroad. If import prices rise faster, the terms of trade deteriorate.

The measure is used by central banks, finance ministries and the International Monetary Fund (IMF) to judge how world price movements affect a country's real income. It is closely watched in economies that depend on a few commodities. It should not be confused with the real effective exchange rate (REER), which compares price levels across countries rather than the prices of what a country sells and buys.

Think of a farmer who sells mangoes and buys fertiliser. One year, a crate of mangoes buys two bags of fertiliser. The next year mango prices jump while fertiliser stays the same, and the same crate now buys three bags. The farmer is better off without working any harder. If instead fertiliser becomes dearer, the farmer has to sell more mangoes just to buy the same amount.

A whole country is in the same position. When the things it sells become relatively more valuable, it can afford more from abroad. When they lose value, it must export more just to stand still.

The standard net barter terms of trade index is:

• $P_X$ is an index of export prices (or export unit values).
• $P_M$ is an index of import prices, with both indices set to 100 in the same base year.

Worked example: in the base year both indices are 100, so ToT is 100. A year later export prices have risen 10% to 110 and import prices 5% to 105. The terms of trade are $110 \div 105 \times 100 \approx 104.8$, an improvement of about 4.8%. Had export prices stayed at 100 while import prices rose to 105, the index would fall to about 95.2.

A related measure, the income terms of trade, multiplies the ratio by the volume of exports $Q_X$, giving $\frac{P_X}{P_M} \times Q_X$. It shows the capacity to import that export earnings provide: a country with worsening price terms can still import more if it sells enough extra volume.

• Commodity prices. For exporters of oil, gas, copper, iron ore or farm goods, the terms of trade follow world prices of each commodity and the wider commodity cycle. Production decisions by the Organization of the Petroleum Exporting Countries (OPEC) move the terms of trade of oil exporters and importers in opposite directions.
• Exchange rates. When a currency weakens, import prices in local currency usually rise faster than export prices, worsening the terms of trade in the short run even as exports become more competitive. How the exchange rate feeds through depends on the currency in which goods are invoiced, often the United States dollar (USD).
• Product mix and quality. Countries that move into higher-value manufacturing and services can lift export prices relative to import prices.
• Trade policy. A large importing country that imposes a tariff may push down the world price of its imports and gain on its terms of trade at its suppliers' expense, an argument known in trade theory as the optimal tariff.

Large, sudden swings are called terms-of-trade shocks. The 1973–74 and 1979 oil price rises sharply improved the terms of trade of oil exporters and hit importers, contributing to stagflation in many advanced economies. During the 2000s commodity boom, Australia, Chile and many Gulf and African exporters enjoyed large gains; Australia's terms of trade reached record highs around 2011. In 2022 the jump in gas prices after Russia's invasion of Ukraine worsened the terms of trade of energy importers in Europe and South Asia, adding to inflation and widening current account deficits.

A favourable shock raises national income but can bring problems: currency appreciation that squeezes other exporters, spending booms and dependence on a single product, issues discussed under the resource curse. Some exporters save windfalls in a sovereign wealth fund (SWF) to smooth such swings.

In 1950 the economists Raúl Prebisch and Hans Singer, working separately, argued that the prices of primary commodities tend to fall over the long run relative to the prices of manufactured goods. If true, developing countries that export raw materials would face steadily worsening terms of trade. The idea shaped import-substitution policies in Latin America and elsewhere and the founding agenda of UNCTAD.

The evidence is mixed. Many long-run studies find a modest downward trend in real commodity prices across the twentieth century, but with long cycles, structural breaks and large differences between commodities; the 2000s boom reversed decades of decline for many exporters. Critics note that rising quality of manufactured goods is hard to price, which may bias the comparison, and that diversification matters more than the trend itself. Supporters say the volatility alone justifies policies to diversify away from primary exports, a theme taken up in work on the middle-income trap and industrial policy.

• UNCTADstat