Terms of trade is the relationship between the average price of exports and the average price of imports.  It is calculated using the following formula:

Terms of Trade =    Index of export prices
—————————————    X    100
Index of import prices

The average price of exports or imports is expressed as an index number. This means that it is measured against a base year which normally is given an index of 100. For example, if average export price has increased by 10%, the index of export prices will be 110 (100 + 10) from the base year. If average import price has fallen by 10%, the index of import prices will be 90 (100-10) .

The terms of trade is favourable  if it rises above 100.  It becomes unfavourable if it falls below 100.

The terms of trade is favourable if fewer exports can be sold to purchase an amount of imports. Every unit of exports can buy more imports. A favourable terms of trade will be greater than 100. For example,  if export prices have, on average, increased by 20% and import prices have risen by 10%, the terms of trade is 109.09; it is favourable and has improved by 9.09% (109.09 – 100) over the base year. The calculation is shown below.

Terms of Trade =   120 (100 + 20)
————————     X      100
110 (100 + 10)

=   109.09

The reasons why there will be a favourable terms of trade, i.e. obtaining a number greater than 100, are:
(1) Both export and import prices are rising but export prices are rising faster, e.g. export prices increase by 10% while import prices rise by 5%.

(2) Export prices remain unchanged while import prices fall, e.g. export prices remain the same but import prices fall by 15%.

(3) Both export and import prices are falling but import prices are falling faster, e.g. export prices fall by 30% while import prices fall by 50%.

An unfavourable terms of trade means that a each unit of export can buy lesser amount of  imports. An unfavourable terms of trade is less than 100. As an example, if export prices fall by 30% and import prices fall by 20%, the terms of trade is 87.5; it has worsened by 12.5% (100 – 87.5) from the base year. The calculation is shown below.

Terms of Trade =   70 (100 – 30)
————————     X      100
80 (100 – 20)

=   87.5

The terms of trade will be unfavourable or less than 100 if:

(1) both export and import prices are rising but import prices rise faster, e.g. export prices rise by 15% while import prices rise by 30%.

(2) import prices are unchanged while export prices fall, e.g. import prices are unchanged while export prices fall by 5%.

(3) both export and import prices are falling but export prices are falling faster, e.g. export prices decrease by 10% while import prices fall by 5%.

Is favourable terms of trade good?

Having a favourable terms of trade is not always good for a country. It depends on the cause.
If export prices are rising faster than import prices because of increased demand for a country’s products by other countries, there will be  a favourable terms of trade. This is good. This may be because the products are competitive in terms of quality or prices. There will be more sales revenue for domestic exporters,  more jobs for the people and more tax revenue for the government.

A rise in the inflation rate in an economy compared to other economies will make its export prices increase and experience a favourable terms of trade. It is not good in this case. Its products will be  non-competitive in foreign markets and the volume of exports will decline in favour of cheaper alternatives. Export revenue drops, domestic jobs may suffer and the country may have a current account deficit.

Rising exchange rate makes export prices increase and import prices decrease. Exchange rate may rise due to the market forces (appreciation) or government action (revaluation). This will decrease the demand for the country’s exports in the international market. The negative effects on an economy include reduced export sales, current account deficit, unemployment and fall in government tax revenue.

If the exchange rate of a country is overvalued, there will be a favourable terms of trade. Exports will expensive while imports will be cheaper; it will cause a current account deficit as exportation decreases while importation increases. An exchange rate may be deemed overvalued if it is more than what is obtainable using the Purchasing Power Parity (PPP). PPP compares the price of the same good in two countries. If, for instance, the same basket of goods costs \$2 in the US and £1 in the UK, according to PPP, the exchange rate should be \$2 to £1. But if actual exchange rate is \$3 to £1, then the US dollar in undervalued in relation to the UK pound.

The reason why a country has unfavourable terms of trade determines whether it is bad or not. A country’s government  can intentionally devalue its currency in relation to other currency to make its exports cheaper and attract foreign buyers. Devaluation is the reduction of the value of a country’s currency in terms of other currencies. The terms of trade will become unfavourable or deteriorate; however, this not bad for the country. Export revenue will increase and domestic jobs will be created. China devalued its currency in order to grow its economy through exports expansion. The only problem here is that import prices will rise as export prices fall due to devaluation. This may fuel inflation for a country that imports raw materials and components. It will also reduce importation.

Another reason for having an unfavourable terms of trade is declining demand for exports caused by low quality or high prices.  When demand for exports fall, export prices will fall in relation to import prices, causing the terms of trade to become unfavourable. This is not good for the country as low export sales may stifle domestic firms and increase unemployment rate.

Import prices have been falling owing to globalisation. Countries are becoming more interdependent and international competition is pushing prices downward. An export-oriented country will see its export prices dropping and terms of trade becoming unfavourable. Export volume increases and export revenue rises.

Prebisch-Singer hypothesis
This hypothesis states that the terms of trade is unfavourable for countries that depend on export of primary products because they get low prices for their exports and pay higher prices for their import of manufactured products.  Primary products exporters are developing countries that depend on developed countries for most of their import of  manufactured products. Primary products do not attract a lot of demand when there is a global rise in incomes because they are income-inelastic, i.e.  a rise in income leads to a smaller percentage rise in quantity demanded. Manufactured products, on the other hand, experience a greater increase in demand as a result of income rises. Therefore, the terms of trade tends to be more favourable to developed countries at the expense of developing countries.

In addition, these primary products that include agricultural products and mineral resources are volatile in supply and prices.  And this makes then unreliable sources of income for countries that depend on them. A fall in price will increase quantity demanded by a smaller percentage and reduce revenue. This explains why citizens of countries with a lot of mineral resources have poor living standards.