The terms of trade measures the rate of exchange of one product for another when two countries trade.
David Ricardo's theory of comparative advantage explains that if countries specialise in the production of the good/service in which they have a comparative advantage, then all countries can move outside their PPF and gain from trade. How the gains from trade are distributed depends on the terms of trade.
We calculate the terms of trade as an index number using the following formula:
Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index
If a country can buy more imports with a given quantity of exports, its terms of trade have improved.
For example, during the commodity price boom, many resource-exporting developing countries experienced increases in their terms of trade. In other words, for the same physical quantity of exports (copper, rubber, oil etc.) as before, they could buy more consumer and capital goods from abroad
If import prices rise faster than export prices, the terms of trade have deteriorated. A greater volume of exports has to be sold to finance a given amount of imported goods and services. Typically this leads to a fall in the standard of living because imports of food and technologies are more costly
The terms of trade fluctuate in line with changes in export and import prices. The exchange rate and the rate of inflation can both influence the direction of any change in the terms of trade
A key variable for many developing countries is the world price received for primary commodity exports e.g. the world export price for Brazilian coffee, raw sugar cane, iron ore and soybeans.
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