# Terms of trade

> Economics · CIE A-Level
> Source: https://www.owlsprep.com/study/cie-9708-u7-terms-of-trade/

This module explains how to calculate, interpret and analyse movements in terms of trade (TOT), a key concept for evaluating how international trade affects a country's economic welfare and macroeconomic performance.

**Prerequisites:** [Price indices and base year calculations](https://www.owlsprep.com/study/cie-9708-u2-price-indices/); [Introduction to international trade](https://www.owlsprep.com/study/cie-9708-u7-introduction-international-trade/)

## Learning objectives

- Define terms of trade and calculate the terms of trade index
- Distinguish between favourable and unfavourable movements in terms of trade
- Explain the main causes of changes in terms of trade
- Analyze the impact of terms of trade changes on economic welfare

## Definition and Calculation of Terms of Trade

Terms of trade (TOT) is a core macroeconomic concept that measures how many units of imports an economy can purchase for one unit of exports. It is presented as an index to track changes over time relative to a base year.

**Terms of Trade Index** — A weighted index that compares the average price of a country's exports to the average price of its imports, standardized to a base year of 100.

*Notation:* TOT

$$\text{TOT} = \frac{\text{Export Price Index (XPI)}}{\text{Import Price Index (MPI)}} \times 100$$

**Worked example:** In 2020 (the base year), both export and import price indices equal 100. By 2023, the export price index rises to 120 and the import price index rises to 110. Calculate the 2023 terms of trade index and describe the movement.

1. Substitute the values into the TOT formula:

   $$TOT = \frac{120}{110} \times 100$$
2. Calculate the final value:

   $$TOT \approx 109.09$$
3. Interpret the result: The 2023 TOT is higher than the base year value of 100. This means each unit of exports buys more imports than in 2020, so this is a **favourable movement** in terms of trade.

## Favourable vs Unfavourable Movements

A change in the TOT index is labelled based on its direction. The terms *favourable* and *unfavourable* only describe the direction of change, not whether the change is actually good or bad for the economy.

**TOT Movement** — A change in the TOT index from a previous period. A rising index is an improvement (favourable), a falling index is a deterioration (unfavourable).

> **warning**
>
> Never assume that a favourable movement is always beneficial and an unfavourable movement is always harmful. The welfare impact depends entirely on what caused the change in TOT.

**Worked example:** A country had a TOT index of 105 in 2022. In 2023, export prices fall by 10% and import prices stay constant. Calculate the new TOT and state the type of movement.

1. Adjust the export price index for the 10% fall (base year XPI = 100):

   $$\text{New XPI} = 100 - (10\% \times 100) = 90$$
2. Import price index is unchanged at 100, so calculate new TOT:

   $$TOT = \frac{90}{100} \times 100 = 90$$
3. Compare to the 2022 TOT of 105: 90 < 105, so this is an **unfavourable movement** in terms of trade.

## Causes of Changes in Terms of Trade

Terms of trade change when export prices, import prices, or both change relative to each other. Common causes of shifts in TOT are listed below:

- * **Exchange rate changes**: Currency appreciation raises export prices and lowers import prices, improving TOT; depreciation does the opposite.
- * **Global demand shifts**: A rise in global demand for a country's exports raises export prices, improving TOT.
- * **Productivity changes**: Higher productivity in the export sector lowers export prices, worsening TOT ceteris paribus.
- * **Supply shocks**: A global shortage of a country's main export raises export prices, improving TOT.
- *

- * **Exchange rate changes**: Currency appreciation raises export prices and lowers import prices, improving TOT; depreciation does the opposite.
- * **Global demand shifts**: A rise in global demand for a country's exports raises export prices, improving TOT.
- * **Productivity changes**: Higher productivity in the export sector lowers export prices, worsening TOT ceteris paribus.
- * **Supply shocks**: A global shortage of a country's main export raises export prices, improving TOT.
- * **Inflation differences**: Higher domestic inflation than trading partners raises export prices relative to imports, improving TOT.

**Worked example:** Country A exports coffee and imports manufactured goods. A severe drought destroys half of Country A's coffee crop. What is the impact on Country A's terms of trade?

1. The drought reduces the global supply of coffee, Country A's main export. Reduced supply pushes up global coffee prices, so Country A's export price index (XPI) rises.
2. The drought has no impact on global prices of manufactured imports, so the import price index (MPI) stays constant.
3. Since TOT = XPI/MPI × 100, a higher XPI with constant MPI increases the TOT index. This causes a **favourable movement** in Country A's terms of trade.

## Impact of TOT Changes on Economic Welfare

The welfare impact of a TOT change depends entirely on the cause of the change. The table below summarizes common scenarios:

| Cause of favourable TOT | Welfare Impact | Key Stakeholders |
| --- | --- | --- |
| Rising global demand for exports | Overall positive: higher export revenue, more imports per unit export | Export producers gain, whole economy gains from higher income |
| Export supply shortage | Ambiguous: higher price per export but lower export volume | Welfare rises if export demand is inelastic, falls if elastic |
| Currency appreciation | Mixed impact | Consumers gain from cheaper imports; export producers lose |

**Worked example:** Country B imports most of its oil. A global oil glut cuts oil prices by 40%. What is the impact on Country B's terms of trade and economic welfare?

1. Oil is an import for Country B, so falling oil prices reduce the import price index (MPI).
2. Export prices (XPI) are unchanged, so TOT = XPI/MPI × 100 increases. Country B experiences a **favourable movement** in terms of trade.
3. Welfare impact: Cheaper oil reduces production costs and consumer energy prices, increasing consumer surplus and overall economic welfare. This favourable movement is unambiguously beneficial for Country B.

> **Exam Tip**
>
> In essay questions, always link the welfare impact to the cause of the TOT change. Examiners specifically look for this nuance.

> **Exam tip:** Always explain the impact of TOT changes by their cause, not just the direction of movement

## Common pitfalls

- **Wrong:** Assuming a favourable terms of trade movement is always good for the economy
  - Why it fails: The label 'favourable' only describes direction of change, not welfare impact. A favourable movement can come from negative shocks like export crop failures that reduce total output.
  - Correct: Always evaluate welfare impact based on the cause of the TOT change, not just the direction of movement.
- **Wrong:** Reversing the TOT formula: writing TOT = (MPI / XPI) × 100
  - Why it fails: This reverses the interpretation of movements, leading to wrong conclusions in calculation and explanation questions.
  - Correct: Remember: Exports come first: TOT = (Export Price Index / Import Price Index) × 100.
- **Wrong:** Claiming currency depreciation improves the terms of trade
  - Why it fails: Depreciation lowers export prices in foreign currency and raises import prices in domestic currency, which reduces the TOT index.
  - Correct: Depreciation causes an unfavourable movement in TOT; appreciation causes a favourable movement, ceteris paribus.
- **Wrong:** Forgetting to multiply the XPI/MPI ratio by 100 when calculating the TOT index
  - Why it fails: CIE markers require the index to be presented in standard base-100 form, so this step earns an explicit mark that is often lost.
  - Correct: Always multiply the ratio of price indices by 100 to get the standard TOT index.

## Cheatsheet

| Concept | Key Detail | Interpretation |
| --- | --- | --- |
| TOT Index Formula | (XPI / MPI) × 100 | Base year = 100 |
| Favourable TOT | TOT rises | 1 export unit buys more imports |
| Unfavourable TOT | TOT falls | 1 export unit buys fewer imports |
| Currency Appreciation | XPI ↑, MPI ↓ | TOT improves (rises) |
| Currency Depreciation | XPI ↓, MPI ↑ | TOT deteriorates (falls) |
| Rising Export Prices | XPI ↑ | TOT improves |
| Rising Import Prices | MPI ↑ | TOT deteriorates |

## What's next

Understanding terms of trade is essential for analyzing the distribution of gains from trade, the impact of exchange rate fluctuations, and the economic challenges faced by primary commodity-exporting developing countries. This concept also underpins analysis of how trade policies affect domestic and global welfare, and how economies adjust to balance of payments disequilibrium. The Prebisch-Singer hypothesis, a key theory in development economics that focuses on long-run trends in terms of trade for developing countries, also builds directly on this foundation.

- [Free trade vs protectionism](https://www.owlsprep.com/study/cie-9708-u7-free-trade-vs-protectionism/)
- [Types of protectionist policies](https://www.owlsprep.com/study/cie-9708-u7-types-of-protectionist-policies/)
- [World Trade Organization](https://www.owlsprep.com/study/cie-9708-u7-world-trade-organization/)

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