Often, as economists, we are interested in measuring how expensive imports are compared to the price received for exports.

The Terms Of Trade (TOT) measures the relative price of exports to imports. It is defined as:

$$TOT = \frac{P_{exports}}{P_{imports}}$$

where $$P_{exports}$$ is an export price index and $$P_{imports}$$ is an import price index.

The terms of trade are said to have improved when there is an increase in the terms of trade. This occurs when the price of exported commodities increased compared to the price of imported commodities. When this occurs, the exporting country becomes less competitive compared to the rest of the world. Generally, an improvement in the terms of trade is associated with an improvement in living standards because countries are giving up less of their own goods in exchange for foreign goods.

A deterioration in the terms of trade occurs when there is a decrease in the terms of trade. This occurs when the price of imports rises compared to the price of exports. When this occurs, the exporting country becomes more competitive compared with the rest of the world. A deterioration in the terms of trade is usually associated with a decrease in living standards as countries are now required to give up more of their own goods in exchange for imported commodities.

### Determinants of the terms of trade

Commodity prices – For small resource-endowed countries, like Australia, an increase in commodity prices will usually cause an improvement in the terms of trade.

Exchange rate – A fall in the exchange rate will usually cause a deterioration in the terms of trade as it makes exports cheaper and imports more expensive.

### Calculating import and export prices

Consider an economy with the following imports and exports. This country imports Bananas and Apples and exports oranges and cherries.

This data can be used to calculate the import and export price indices. Simply calculating the arithmetic average of all imported or exported commodities would be the easiest way to do this. For example, we could calculate the import price index as:

$$P_{imports} = \frac{4 + 1}{2} = 2.5$$

The shortcoming of this method is that consumers in this economy spend more money on apples than they do on bananas. A better way to calculate the import price index would be to calculate a share-weighted average, using the expenditure shares as the weights. The import price index is calculated:

$$P_{imports} = (\frac{100}{100+ 300}) 4 + (\frac{300}{100 + 300})1 = 1.75$$

We can see the import price is lower when we use the second formula because it places a higher weight on the cheaper commodity on which consumers spend more money.

The export price index can be calculated in the same manner using export prices and expenditure on exports:

$$P_{exports} = (\frac{400}{100+ 400}) 2 + (\frac{100}{100 + 300})6 = 2.8$$

The terms of trade can be calculated by dividing the export price index by the import price index:

$$TOT = \frac{2.8}{1.75} = 1.6$$

The terms of trade show that consumers in this economy can purchase 1.6 units of imported goods for each unit of exported goods.

### Is a favourable move in terms of trade good?

An increase in terms of trade holding everything else constant is always a welfare enhancing outcome. A country is now has to give us less goods to import the same amount of goods as before. However, the observation that the terms of trade does not necessarily mean that welfare has increased.

For example, the price of exports could increase by 10%, causing the terms of trade to improve, but the quantity of exports could decrease by 40% which might counteract the benefits of a higher price.