Terms of Trade Definition, Importance, Formula & Overview

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Definition: Terms of Trade

Terms of trade describes the relationship between the export price per unit of a product and import price per unit of a product of any country. Sometimes terms of trade is referred to as the share of the index of export prices to the index of the import prices of a country. Terms of trade is used as an indicator for the economic health of a nation and depicts the balance of import-export trades and policies.

Importance of Terms of Trade

Generally the ratio of terms of trade balance is considered to be 100%, i.e. when the ratio of export index to import index is 1. The value below 100% signifies the increase in values of imports than exports and creates a potential position for a country to account in trade deficit while a value more than 100% depicts a positive sentiment and denotes a surplus for the trade economy. The ratio is largely affected by the import export trade policies of the nation, world economic development and demand, foreign currency exchange values and either macroeconomic factors for the nation and the world both. There might be instances of seasonality and cyclicity in demand for specific exports in specific time bound periods of the financial year. The terms of trade ratio is calculated in monthly, bi-monthly, quarterly and yearly basis to keep a tab on the economic health of the nation and optimize the balance of payment.

In the instance of a positive ‘terms of trade’ there might be three possible situations

1. The import prices take a fall in the trade and export prices remain same

2. The export prices take a rise and import prices remain same

3. The export prices rise while the import prices fall

Terms of Trade

Formula for Terms of Trade

Terms of trade can be expressed mathematically as:

Terms of trade = Average Export Price Index / Average Import Price Index

In the case of a downshift terms of trade the economic condition comes to a trigger of price adjustment and trade regulation wherein high volumes of export are made to counter the effect of the fallen exchange rate. Exchange rates fall due to global currency pressure, demand and supply of the currency, capital market adjustments, trade wars, regional disturbances, economic development and GDP. These indicators affect the price of a currency which in turn regulates the price level of exports as well as the value of imports. Major macroeconomic factors such as change in the governmental regime, adjustments in the monetary policies, inflation, total demand and supply, natural factors and unemployment greatly affect the currency values and in turn hit the trade terms of a country as the trade is facilitated by the currency and the exchange rates.

However, there are similarities between the terms of trade and the balance of trade. Both of the concepts deal with the broad profiling of the import and export regulation and trade but terms of trade deal in only the indexes of price and does not affect the trade sentiments while the latter is the measure of trade adjustments and usually carry a long adjustment procedure after the figures have been calculated and averaged out. Goals are set for achieving the minimum and maximum target of each parameter and monetary policies are hence adjusted to meet the set targets.

Hence, this concludes the definition of Terms of Trade along with its overview.

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