Terms of trade

The terms of trade (TOT) measures the ratio of export prices to import prices, such that:

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

where P_{exports} is a price index for all exported goods and P_{imports} is a price index for all imported goods.

There are a range of different techniques which can be used to measure the price index for exports and imports.

Favorable and unfavorable change in terms of trade

A Favorable change in the terms of trade is when the price of exports relative to the price of imports increase, such that the terms of trade increases.

An unfavorable change in the terms of trade is when the price of exports relative to the price of imports decreases, such that the terms of trade decreases.

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.

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