Question

What is Terms of Trade? How is it computed?

Answer 1

The terms of trade is the rate of exchange between one country’s products with another country’s product. In other words it is the ratio between a country’s export and its import. This ratio shows how much export is required for a given amount of import. This rate determines the gain or loss of international trade. If a country has favourable terms of trade, the country it will get larger quantity of import and for a given quantity of export. During the unfavorable balance of trade, the country gets smaller quantity of import compared to its export. The terms of trade depends upon the relative changes in export price and import price. When export price increase relative to import price a country gets larger quantity of import over its export. Then the terms of trade said to be favourable to the country. On the other hand if the export price is lower than the import price the country gets smaller quantity of import over its export and the terms of trade is said to be unfavorable to the country.

The terms of trade is calculated by dividing export price with the import price and multiplying with 100. For this first of all we have to calculate the export price index and import price index. These indices are average of the change in price from one period another.

The formula for finding terms of trade: Index of export prices/index of import prices × 100.

Consider the price indices for export and import for a country ‘A’ between the periods from 2015 to 2018 as shown in the following table.

Year	Index of export prices	Index of import prices
2015	102	98
2016	94	100
2017	92	99
2018	105	103

TOT for 2015 = 102/98×100=104

2016=94/100×100=94

2017=92/99×100=93

2018= 105/103×100=102

From the above table it is observed that the terms of trade deteriorated between the years 2015 and 2016, 2016 and 2017. But it improved between 2017 and 2018.

The improvement and deterioration in the terms of trade depend upon the relative elasticity of demand for export and import. If the demand for export and import is inelastic, country’s the terms of trade improves and the country enjoys a favourable balance of payment with a rise in export price and a surplus balance of payment. Contrary if the demand for export and import are elastic the country will suffer from deterioration in the terms of trade and deficit in the balance of payment.