Terms of trade
EconomicsΒ· Unit 7: International TradeΒ· 15 min read
1. Definition and Calculation of Terms of Tradeβ β ββββ± 5 min
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.
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:
- 2
Calculate the final value:
- 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.
2. Favourable vs Unfavourable Movementsβ β ββββ± 5 min
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).
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):
- 2
Import price index is unchanged at 100, so calculate new TOT:
- 3
Compare to the 2022 TOT of 105: 90 < 105, so this is an unfavourable movement in terms of trade.
3. Causes of Changes in Terms of Tradeβ β β βββ± 6 min
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.
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- 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.
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 Γ 100, a higher XPI with constant MPI increases the TOT index. This causes a favourable movement in Country A's terms of trade.
4. Impact of TOT Changes on Economic Welfareβ β β βββ± 7 min
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 |
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 Γ 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:
Always explain the impact of TOT changes by their cause, not just the direction of movement
5. Common Pitfalls
Wrong move:
Assuming a favourable terms of trade movement is always good for the economy
Why:
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 move:
Always evaluate welfare impact based on the cause of the TOT change, not just the direction of movement.
Wrong move:
Reversing the TOT formula: writing TOT = (MPI / XPI) Γ 100
Why:
This reverses the interpretation of movements, leading to wrong conclusions in calculation and explanation questions.
Correct move:
Remember: Exports come first: TOT = (Export Price Index / Import Price Index) Γ 100.
Wrong move:
Claiming currency depreciation improves the terms of trade
Why:
Depreciation lowers export prices in foreign currency and raises import prices in domestic currency, which reduces the TOT index.
Correct move:
Depreciation causes an unfavourable movement in TOT; appreciation causes a favourable movement, ceteris paribus.
Wrong move:
Forgetting to multiply the XPI/MPI ratio by 100 when calculating the TOT index
Why:
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 move:
Always multiply the ratio of price indices by 100 to get the standard TOT index.
6. Quick Reference Cheatsheet
Concept | Key Detail | Interpretation |
|---|---|---|
TOT Index Formula | (XPI / MPI) Γ 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 β, MPI β | TOT improves (rises) |
Currency Depreciation | XPI β, MPI β | TOT deteriorates (falls) |
Rising Export Prices | XPI β | TOT improves |
Rising Import Prices | MPI β | TOT deteriorates |
7. Frequently Asked
Is a favourable terms of trade always good for an economy?
No. A favourable TOT from rising export prices can boost income, but if the rise comes from falling export supply, it may reduce total export revenue. An unfavourable TOT from cheaper imports can also increase consumer welfare.
How does currency depreciation affect terms of trade?
Depreciation makes exports cheaper in foreign currency and imports more expensive in domestic currency. Ceteris paribus, this reduces the TOT index, causing an unfavourable movement.
When this came up on past exams
AI-estimated based on syllabus patterns β cross-check with official past papers for accuracy. Use only as revision-focus signals.
- 2022 Β· 22
Calculate TOT, discuss welfare impact
- 2021 Β· 12
Explain causes of falling TOT
- 2020 Β· 21
Distinguish favourable vs adverse TOT
Going deeper
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.