Econ 101, Part 6: Trade, Exchange Rates & Globalization
Terms of Trade
What the terms of trade measure, why changes in export and import prices can make a country richer or poorer, and why commodity exporters watch them closely.
A country’s terms of trade compare the prices of its exports with the prices of its imports. They show how many imports a country can buy with a given amount of exports.
How it is measured
The terms of trade are usually calculated as an index of export prices divided by an index of import prices, multiplied by 100. If export prices rise faster than import prices, the terms of trade improve: the country can buy more imports for the same exports. If import prices rise faster, they worsen.
Why it matters
Improving terms of trade make a country richer, even if it produces the same amount, because its exports buy more. Worsening terms of trade make it poorer.
This matters most for countries that export mainly one type of product. A copper exporter benefits when copper prices rise relative to the machinery and fuel it imports, and suffers when they fall.
India’s terms of trade
India imports large amounts of crude oil. When oil prices rise sharply, India’s terms of trade worsen: it must export more to pay for the same oil. When oil prices fall, India benefits. This is one reason oil prices matter so much for India’s trade deficit, inflation and currency.
A country exports coffee and imports tractors. One year, a tonne of coffee buys one tractor. If coffee prices double while tractor prices stay the same, a tonne of coffee now buys two tractors. The country's terms of trade have improved, and its farmers can afford more machinery without growing more coffee. If coffee prices crash, the reverse happens.
The Prebisch-Singer hypothesis
In the 1950s, economists Raúl Prebisch and Hans Singer argued that the prices of raw commodities tend to fall over the long run relative to manufactured goods, worsening the terms of trade for commodity exporters. The evidence has been debated, with commodity prices showing long cycles as well as possible long-run declines.
The trade balance measures the difference between the value of exports and imports. The terms of trade measure relative prices. A country can have a trade surplus while its terms of trade worsen, or vice versa.
- The terms of trade compare export prices with import prices.
- Improving terms of trade let a country buy more imports for the same exports.
- Commodity exporters and big oil importers like India are especially affected.
- The Prebisch-Singer hypothesis argued commodity exporters' terms of trade tend to worsen.
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