Terms of trade (TOT)
Terms of trade (TOT) refers to the rate at which a country's exports can be exchanged for its imports, measuring the relative prices of these goods. It plays a crucial role in international trade, influencing what countries gain from their trading relationships. An improvement in a country's terms of trade, indicated by an index number greater than 100, means it can buy more imports for the same quantity of exports, which is generally seen as advantageous. Conversely, a decline, represented by an index number below 100, suggests a country must export more to maintain its import levels, potentially leading to adverse economic outcomes.
Several factors impact terms of trade, including reciprocal demand, competitive conditions, tastes, currency value fluctuations, and trade policies such as tariffs and quotas. Various concepts within TOT, such as net barter terms, income terms, and factoral terms, provide deeper insights into how trade dynamics operate. Notably, terms of trade often favor industrialized nations, which export manufactured goods compared to less developed countries that primarily export raw materials. The Prebisch-Singer hypothesis illustrates this disparity, indicating that primary goods tend to lose value compared to manufactured goods over time, placing developing nations at a disadvantage. Understanding terms of trade is essential for analyzing a country's economic health and its position in the global market.
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Terms of trade (TOT)
In international finance, terms of trade refer to the rate that a country's exports can be exchanged for its imports. It measures export prices relative to import prices. Terms of trade help determine what a country gains from international trade. When two countries trade goods, each country seeks better terms of trade. However, when the terms favor one country, they adversely affect the other.
Different concepts of terms of trade include net barter (or commodity) terms of trade, income terms of trade, single factorial terms of trade, and double factorial terms of trade. Factors affecting terms of trade include reciprocal demand, competitive conditions, tastes, devaluation, and tariffs and quotas. Nations usually benefit from improving their terms of trade, but the index is not a valid indicator of a country's economic health.
Background
A country's terms of trade are calculated as an index number. To determine a nation's terms of trade, the price of its exports is divided by the price of its imports and then multiplied by 100. A nation's terms of trade are improving when the index number is more than 100. This means that for each unit of exports sold, the country can buy more units of imported goods. Increases in a country's terms of trade are called favorable movements. The terms of trade will rise when the prices of exports increase in relation to the price of imports. They will also increase when the prices of exports and imports go up, as long as the price of exports rises more than the price of imports.
A nation's terms of trade are declining when the index number is less than 100. This means the country must export more units to buy the same amount of imports. Decreases in a country's terms of trade are called unfavorable movements. The terms of trade will fall when the prices of imports increase relative to the price of exports.
A country can benefit from an improvement in terms of trade. This could mean the country sold a higher amount of exports to purchase a given number of imports. The increase in terms could also favorably affect a country's cost-push inflation, or rising prices due to an increase in the price of raw materials. When terms of trade improve, it may indicate the prices of imported commodities are dropping.
Terms of trade usually favor industrialized nations over less developed countries. Industrialized nations export manufactured goods, while less developed countries export primary products, or raw materials. The Prebisch-Singer hypothesis states that the price of primary goods declines in the long run relative to manufactured goods, leading to worsening terms of trade for less developed nations. As a result, the emerging nations must export more of their lower-priced primary products to import higher-priced manufactured goods.
Nations favored by terms of trade usually realize increases in national and real income—the latter after it is adjusted for inflation. If countries improve their terms of trade by selling more exports, they will increase production of the exported good, thereby increasing employment.
Countries at a disadvantage in terms of trade could lose millions or possibly billions of dollars. If terms of trade decline, they are forced to export more and import less. Industrialized countries can also be affected negatively, such as when the price of oil from oil-producing nations spikes.
Overview
Terms of trade encompass related concepts that further examine trade conditions between two countries. These concepts include the following:
- Net barter terms of trade (or commodity terms of trade) look at price relations only between exports and imports. An increase in terms of trade indicates a country can receive a higher volume of imports in exchange for a set volume of exports. This measure is considered relevant when commodities, not services, are traded.
- Income terms of trade measure a country's capacity to import. It can be calculated as the ratio of the value of exports divided by the price of imports. Given import prices, if export prices increase and the volume of exports decreases at the same rate, net barter terms of trade will improve while the income terms of trade indicate no change.
- Single factorial terms of trade adjust for changes in productivity in the production of export goods. An increase in single factorial terms of trade means a higher number of imports can be obtained per unit of factor input, which is favorable.
- Double factorial terms of trade adjust for changes in productivity in the production of imports and exports. An increase in double factorial terms of trade is favorable, as it indicates a unit of the home factors can garner more units of foreign factors in imports.
A variety of factors can affect a country's terms of trade:
- Reciprocal demand: When demand for the country's exports is less price elastic—the quantity demanded is little affected by a big change in price—than its imports, exports can receive a higher price than imports. The terms of trade are, therefore, favorable.
- Competitive conditions: The absence of competition in a country's market for its exportable goods favors terms of trade. Without competing products, a country or entity has more control over output and price. For example, the Organization of Petroleum Exporting Countries, or OPEC, controls oil output.
- Tastes: If a country's population wants more goods from another country, this increases the demand for imports. This leads to declining terms of trade.
- Devaluation: A decrease in the value of a nation's currency makes exports cheaper and imports more expensive in other countries. This increases exports and decreases imports, making the terms of trade favorable for the devaluing nation.
- Tariffs and quotas: Tariffs, or taxes on imports, and quotas, or trade limits, decrease imports. This improves the terms of trade for the country imposing the tariff or quota. However, such tactics could backfire if trade partners retaliate by setting their own tariffs or quotas.
Terms of trade are not reliable indicators of a country's state of economic affairs. While most nations seek to improve their terms of trade, such an increase could be harmful. It could reveal a drop in the country's export volume. This could negatively affect the country's balance of payments and their transactions with other countries. Additionally, an increase in export prices could make the goods harder to sell overseas.
When the price of exports rises, the cause should be known. For instance, an increase due to rising demand for the exported good in other countries is favorable to the exporter. Specific conditions can be used to determine whether an improvement in the terms of trade is truly beneficial.
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