Terms of Trade

Terms of trade (TOT) refer to the relationship between how much money a country pays for its
imports and how much it brings in from exports, expressed as the ratio between price of its export
commodity and price of its import commodity.
In a world of many traded commodities, the terms of trade of a nation are given by the ratio of price
index of its exports to the price index of its imports.

When a countrys TOT is less than 100%, it is said to be unfavorable because prices of imports are
higher than its export prices and more capital is going out than coming in.
When the TOT is greater than 100%, said to be favorable because the prices of its exports are higher
than the prices of its imports and the country is accumulating more money from exports than it is
spending.
Illustration
For Nation 1- Export X and Import Y, then terms of trade is N= (Px/Py) x 100
For Nation 2- Export Y and Import X, then terms of trade is N= (Py/Px) x 100
If terms of trade of Nation 1 are increased from 100 to 120 then it means that the price index for the
export increased by 20%. In this situation the import price index in Nation 2 increased by 20% then
terms of trade in Nation 2 will be 83%
Nation 1 Nation 2
Nation 1- Export X and Import Y, then terms of trade is N= Nation 2- Export Y and Import X, then terms of trade is
(Px/Py) x 100 N= (Py/Px) x 100
N= (120/100) x 100 N= (100/120) x 100
N=120% N= 83%

Terms of trade is 120% for Bangladesh in 2015. What does it means?

This means that the terms of trade of Bangladesh have improved by 20% in 2015. Export volume is 20%
greater than import volume.
T.O.T = 120%= (120/100) x100= (Px/Py) x100

Necessity of measurement of Terms of Trade

To understand, what are the changes in production and economic conditions after trade and whether
these changes are favorable to the nation or not.
Terms of trade show gains from international trade. If terms of trade are favorable, it means a country
will gain more from its international trade and the level of incomes will be increased. But if terms of
trade are unfavorable, a country will be gaining less from international trade and level of incomes will
be decreased. So to know what the amount of benefits is from international trade, TOT is needed.
To know export and import situation. Favorable terms of trade show the export is good and
unfavorable terms of trade show, the imports are more than export.
It determines the balance of payments position of a country. Unfavorable terms of trade usually lead
to balance of payments deficit and favorable terms of trade lead to balance of payments surplus. This
determines the importing capacity of an economy.
Terms of trade determine the export revenue earned by government. Export earning can be used to
cover import expenditure. If TOT is 83% that means it can cover 83% of its import expenditure.
TOT measure how many goods need to be exported to buy a given amount of imports.
To some extent it can be used to measure the strength and well-being of an economy. A prolonged
fall in the terms of trade will reduce living standards.

5 ways of measurement of Terms of Trade

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Net Barter Terms of Trade/ commodity terms of trade: The net barter terms of trade is the ratio
between the price index of a countrys export and import multiplied by 100. Symbolically, it can be
expressed as:

Where N stands for the Net barter terms of trade, P for price index, the subscript x for exports and m for
imports.
- A rise in the current years net barter term of trade means that a unit of export will buy more
imports than in the past comparable period. On the other hand,
- A fall in net barter TOT implies unfavorable TOT in the sense that the country will now use more
exports to buy the same quantity of imports.
However such changes do not tell us why relative prices of exports and imports have changed and what
has changed the physical volume of exports and imports
Gross Barter Terms of Trade: The gross barter terms of trade is the ratio between the quantity index of
a country's imports and exports, all expressed in terms of percentage. Symbolically,
G= (Qm/Qx) x100
Where G stands for the gross terms of trade, Qm for quantity index of Imports and Qx for quantity of
exports.
- A rise in the current year's gross barter terms of trade means that more imports are obtained for a
given volume of exports than in the base period.
When trade between two countries is balanced, the net barter terms of trade is equal to the gross barter
terms of trade,
The gross barter terms of trade are least informative since they reflect less price movements than the
change in the balance of payments, and even capital movement.
Income Terms of Trade: The income terms of trade is obtained by weighting the net barter terms of
trade by quantities of exports (Qx). In other words, the income terms of trade is obtained by dividing the
value index of exports (value index= quantity index x price index) by the price index of imports.
The income terms of trade is defined as
I= (Px / Pm) x Qx= (Px x Qx)/ Pm
It is obvious from formula that, given the import prices, if the export prices rise and the volume of
countrys exports fall equally. The net barter terms of trade will improve while the income terms of trade
will show no change.
- A rise in the income terms of trade implies that a country can import more goods in exchange for
its exports.
I measures the nations export based capacity to import. So, the income terms of trade is a concept
superior to the net barter terms of trade for the purpose of less developed countries whose import
capacity is low.
Single Factor Terms of Trade: The single factor terms of trade is the ratio between the export price
index and the import price index adjusted for the change in the productivity index of export. Symbolically,
S= (Px/Pm) Zx
- S measures the amount of imports the nation gets per unit of domestic factors of production
included in its exports.
A rise in S is a favorable phenomenon because it implies that a larger quantity of imports can be obtained
per unit of factor input used in the production of exportable goods.
Double Factor Terms of Trade: When the net barter terms of trade are adjusted for changes in domestic
factors of production embodied in exports and foreign factors of production embodied in imports, it is
called the double Factor Terms of Trade.
D= (Px/Pm) (Zx/Zm) 100
Where Zx is the export productivity index and Zm is import productivity index
- D measures how many units of domestic factors included in the nations exports are exchanged
for per unit of foreign factors included in its imports.

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A rise in D is a favorable phenomenon because it means that one unit of home factors included in exports
can now be changed for more unit of the foreign factors included in imports.
Factors affecting Terms of Trade in Developing Countries/
Why terms of trade is important for developing countries?
1. Elasticity of Demand: Elastic demand means a small change in price results in a large change in
demand. So if the demand for a country's exports is less elastic as compared to her imports, the
terms of trade will be favorable because the exports can command higher price than imports.
On the other hand, if the demand for imports is less elastic than demand for exports, then the prices
of import will be higher and the terms of trade will be unfavorable.
2. Elasticity of Supply If the supply of a country's exports is more elastic than the imports, the terms of
trade will be favorable because the higher the elasticity of supply, the faster the supply will increase
when demand and price increase.
By contracting and expanding the supply of exports in accordance with the market condition it may be
possible to have some control over export price.
3. Availability of substitutes: If the commodities exported by a country have no close substitutes in the
foreign market, the terms of trade will be favorable. Because in such cases, the commodities will be
sale in higher prices. In case of availability of close substitute in the international market, the exports
will fetch relatively lower prices from abroad and therefore, the terms of trade will be unfavorable.
Similarly, if imported goods-have close substitutes in the countrys market, the imports will be lower
and terms of trade will be favorable or in case of non-availability of substitutes in the local market will
turn the terms of trade unfavorable.
4. Size of demand: If demand for a countrys imports increases, it means the prices for imports will also
go up and the terms of trade will be unfavorable, because in such situation, the country will have to
use more exports for buying a given quantity of imports.
On the other hand, if the demand for a countrys exports increases, it means, the prices of exports will
go high and the terms of trade will be favorable because the country will earn more and have to use
less quantity of exports for buying the same quantity of imports.
5. Rate of exchange: A rise in the value of the currency causes an increase in the export prices and
decrease in the import prices. Therefore, terms of trade will be improved.
If a country is import oriented, higher exchange rate means unfavorable terms of trade.
6. Production pattern of a country: If a country is producing and exporting only primary goods, and
importing manufactured goods, the terms of trade will be unfavorable. Similarly-
If a country export agricultural products than it has unfavorable terms of trade compared to a country
who export technology based products. Because the price of the agricultural product is less than
technology based product, even the demand for agricultural product is low with economic
development, because of technological development.
7. Other: Some of the factors of unfavorable terms of trade
- High cost ratios in production
- Backward state of technology
- High population growth
- Greater dependency towards developed countries
- Lack of adaptability.
SLOVE and COMMENT
1. TOT for the base year is 100. Suppose, export price index rises to 120 and import price index
rises to 110. Calculate commodity terms of trade and comment
We know that, Commodity terms of trade, N

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TOT rises to 109. This means that a unit of export will buy 9% more imports than the old TOT. TOT thus
improves.
2. In 2012, the island of Madagascar had an index of export prices of 15% over the previous year
and an index of import prices of 7% over the previous year. Calculate TOT and comment.
Madagascar's TOT = 115 / 107 X 100 = 107.5
The results show an improvement of 7.5% in the TOT. This means that a unit of export will buy 7.5%
more imports than the old TOT
Note: 15% become 115% in the formula because it is over the previous year, the previous year being
100.
3. Taking 1971 as the base year and expressing Indias both quantities of imports and exports as
100, if it is found that the index of quantity imports had risen to 160 and that of quantity
exports to 120 in 1981, then calculate the gross barter trade and comment.
We know that,
Gross barter terms of trade= (Index of import quantities/ Index of export quantities) x 100
G= (Qm/Qx) x100
= (Qm1/Qm0) / (Qx1/Qx0) x 100
= (160/100) / (120/100) x 100
=133%
It implies that there was an improvement in the gross barter terms of trade of India by 33 per cent in 1981
as compared with 1971. In 1981, 33% more imports are obtained for a given volume of exports than in
1971.

4. If the quantity of import index had risen by 130 and that of quantity exports by 180, then the
gross barter terms of trade would be
G = 130/100 / 180/100= 72.22%
This implies deterioration in the terms of trade by 18 per cent in 1981 over 1971. In 1981, 18% less
imports are obtained for a given volume of exports than 1971

5. Taking 1971 as the base year, if Px = 140, Pm = 70 and Qx = 80 in 1981, then Calculate TOT and
comment.
Income terms of trade= (Px/Pm) x Qx = (140/70) x 80= 160
It implies that there is improvement in the income terms of trade by 60 per cent in 1981 as compared with
1971. In 1981 the country can import 60% more goods in exchange for its exports than in1971.

6. If in 1981, Px= 80, Pm =160 and Qx =120, then calculate TOT and comment
Income terms of trade = 80 /160 x 120 = 60
It implies that the income terms of trade have deteriorated by 40 per cent in 1981 as compared with 1971.
In 1981 the country can import 40% less goods in exchange for its exports than in 1971

7. Suppose Bangladesh and India are in international trade with each other. If the price index of
export is 92% in Bangladesh and price index of exports in India is 120% then calculate simple
factor and double factor terms of trade for Bangladesh and comment
[Zx= 110% and Zm= 125%]
Given that, In Bangladesh
Price index of exports Px =92%
As price index of exports in India is 120% that means price index of imports in Bangladesh is 120%
So, Pm= 120%
- Simple Factor TOT= Px/Pm x Zx= (92%/ 120%)x 110%= 84.33%
15.67% less quantity of imports can be obtained per unit of factor input used in the production of export compared to
base year.

- Double Factor TOT= (Px/Pm) x (Zx/Zm) x 100 = (92/120) x (110/125) x 100= 67.76%
One unit of home factors included in exports now will be exchanged for 32.24% less unit of the foreign factors
included in imports compared to base year. Or
32.24% more unit of home factors included in exports now will be exchanged for one unit of the foreign factors
included in imports compared to base year.
Kumkum Sultana (26th Batch, DM, CU)