What is Terms of Trade?

Terms of trade relates to international trade. It is a single number that represents the ratio of a particular country's exports and imports. Specifically, terms of trade represents the relationship between the price a country receives for its exported goods and the price it pays for imported items. In general, terms of trade, also known as TOT, is considered to be more favorable when the price of exports exceeds the price of imports.

To calculate the TOT, the export price is divided by the import price. That result is then multiplied by 100 to determine the TOT percentage. If the final result exceeds 100%, the economy is generally considered healthy. Results under 100% can mean that the economy is not thriving. Results under 100% generally indicate that there is more money going out of the economy than coming in.

An increase in TOT can mean the overall welfare of the country has improved, but not always. This often depends on the reason for the change in prices. The TOT ratio can change based on several internal and external factors affecting a particular country. These may include supply and demand for the products that are imported and exported, as well as local and international economic health. A sudden TOT change can trigger balance of payment problems if the country depends on export receipts to pay for its imports.

The terms of trade can also be affected by the value of a country's currency. When interest rates rise, currency value generally also increases. Export prices typically go up as a result. While the country experiences a higher premium for its goods, it may have trouble finding buyers for these high-priced products. Conversely, if the price of exports fall, the county may be able to sell a much higher quantity of goods.

Historically, developing countries were considered to be at a disadvantage regarding terms of trade. This is because exports are more often raw goods or commodities with lower prices than the manufactured goods imported from more developed counties. This theory has come under scrutiny as more study is completed on how TOT is affected by other factors, including a country's labor pool and foreign investments.

TOT is also known as the terms of trade index. When commodity export prices are compared with manufactured goods' import prices, the ratio is called the commodity terms of trade. Additionally, net barter terms of trade refers to the ratio between export and import prices when volume remains constant.

Source: wisegeek