Terms of Trade (TOT)

Terms of trade refers to the rate at which one country can trade its exports for imports. It is a ratio of the price of a country’s exports to the price of its imports. A country benefits from trade if the terms of trade improve, meaning they can export goods at higher prices while importing at lower prices.

• Favorable Terms of Trade: When the price of exports rises faster than the price of imports, the country gains more purchasing power to buy foreign goods and services, leading to a higher standard of living. For example, if the price of oil exports increases, the country can afford to import more of other goods with the same amount of oil.
• Unfavorable Terms of Trade: If the price of exports decreases relative to imports, the country may have to export more goods to buy the same amount of imports, leading to a reduction in economic well-being.

Calculation of Terms of Trade:
Terms of Trade=(Price Index of Exports) X 100 /Price Index of Imports
An increase in this ratio reflects improved terms of trade, whereas a decrease indicates worsening terms.

Improved TOT: When export prices rise relative to import prices, a country can afford more imports for the same quantity of exports.

Deteriorated TOT: When import prices rise relative to export prices, the country must export more to purchase the same quantity of imports.

Factors Affecting TOT:

1. Demand and Supply: Global demand for exports or imports.
2. Global Prices: Changes in raw material or finished goods prices.
3. Exchange Rates: Currency fluctuations impact import/export costs.
4. Trade Policies: Tariffs, quotas, and trade agreements.
5. Productivity Growth: Higher efficiency in export production.

Significance of TOT:

• Economic Indicator: Reflects a country’s trade competitiveness and economic health.
• Impact on Living Standards: Improved TOT enhances purchasing power and living standards.
• Policy Making: Guides decisions on tariffs, subsidies, and trade agreements.

Types of Terms of Trade:

1. Commodity Terms of Trade (Net Barter TOT):
   • The basic ratio of export prices to import prices.
   • Reflects changes in trade efficiency but ignores trade volume.
2. Income Terms of Trade:
   • Adjusts the commodity TOT by factoring in export volume.
   • Measures the purchasing power of a country’s exports.
   • Formula: Income TOT=Commodity TOT×Export Volume Index 
3. Gross Barter Terms of Trade:
   • Considers the volume of goods exchanged rather than prices.
   • Formula: Gross Barter TOT=Quantity of Exports/Quantity of Imports 
4. Factorial Terms of Trade:
   • Considers changes in productivity and income from trade.