Terms of Trade (TOT): Key Indicators and Economic Impacts Explained

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Terms of trade (TOT) compares the prices a country receives for its exports with the prices it pays for its imports. It is usually reported as an index: the export price index divided by the import price index, multiplied by 100. The result shows how much imported output one unit of exports can buy compared with a base period. TOT is a price ratio, not a measure of trade volumes or of the trade balance.

The terms of trade formula

TOT = (Index of export prices ÷ Index of import prices) × 100

Both indexes are set to 100 in the same base year, so TOT equals 100 in that year. A TOT of 110 does not mean a country earns 10% more from exports than it spends on imports. It means a given basket of exports now buys about 10% more imports than it did in the base period.

Worked example (hypothetical)

• Year A: export price index 120, import price index 110. TOT = 120 ÷ 110 × 100 = 109.1. Export prices rose 20% and import prices 10%, so each unit of exports buys roughly 9.1% more imports than in the base year.
• Year B: export price index 95, import price index 105. TOT = 95 ÷ 105 × 100 = 90.5. The country must ship about 10.5% more exports (100 ÷ 90.5) to pay for the same imports it bought in the base year.

How an improvement can happen

TOT rises whenever export prices outpace import prices. That covers several different situations:

• Export prices rise while import prices are flat or falling.
• Export prices are flat while import prices fall.
• Both rise, but export prices rise faster.
• Both fall, but export prices fall by less.

Other measures of terms of trade

The formula above is the net barter (commodity) terms of trade, the version most often published. Economists also use related measures:

• Gross barter terms of trade: the quantity of imports divided by the quantity of exports.
• Income terms of trade: net barter TOT multiplied by an export volume index. It estimates a country’s capacity to import funded by export earnings, so it can rise even when prices move against the country, provided export volumes grow enough.
• Single factoral terms of trade: net barter TOT multiplied by an index of productivity in the export sector. It asks how many imports a unit of domestic productive effort buys.

What moves terms of trade

Exchange rates. An appreciating domestic currency tends to raise the foreign-currency price of exports and lower the domestic cost of imports, which improves TOT in the short run. The same move can make exports less competitive.

Inflation. If domestic prices rise faster than trading partners’ prices, export prices can climb relative to import prices. This gives a short-term TOT gain, again at some cost to competitiveness.

Commodity prices. Countries whose exports are concentrated in oil, metals or farm goods see their TOT swing with world commodity markets.

Scarcity and supply. The amount of a good available for trade affects its price.

Size, quality and product mix. Larger and higher-quality goods tend to fetch higher prices. Firms that compete on quality or technology can support export prices over time.

Economic effects of changes in TOT

An improving TOT works like a real income gain: the country needs fewer exports to obtain the same imports. Falling import prices relative to export prices can also ease cost-push inflation.

A deteriorating TOT means more exports must be shipped for the same imports. For commodity exporters this can squeeze national income quickly. Developing countries that sell oil, copper and similar goods saw their terms of trade rise during the commodity boom of the early 2000s, allowing a given quantity of commodities to buy more foreign consumer goods.

The Prebisch-Singer hypothesis

Raúl Prebisch and Hans Singer argued that the prices of primary commodities tend to fall over the long run relative to the prices of manufactured goods. If that holds, countries specializing in raw materials face a steadily worsening TOT and must export ever more to import the same machinery and consumer goods. The thesis was used to support industrialization and diversification policies. Since then, globalization has pushed down the prices of many manufactured goods, narrowing part of the advantage industrialized economies once held.

Limitations and common confusions

TOT is not the trade balance. A rising TOT does not by itself produce a trade surplus. Export earnings depend on price and volume. If higher prices cut export volumes sharply, export revenue can fall even as TOT improves.

The cause of a change matters. An export price rise driven by strong foreign demand raises national income. The same rise caused by a poor harvest that leaves less to sell may not.

Index construction. TOT aggregates thousands of goods into two price indexes. Base-year choice, weighting and quality adjustments all affect the reading, and a shift in a country’s export mix can move the index without any change in individual prices.

Growth does not guarantee a favorable TOT. Faster growth concentrated in export industries can raise world supply of those goods and push their prices down, worsening TOT. In extreme cases economists call this immiserizing growth, where the price loss outweighs the output gain.

Not the same as PPP or the exchange rate. Purchasing power parity compares price levels across countries to judge currency values, and the exchange rate is the price of one currency in another. TOT compares the prices of what a country sells abroad with what it buys abroad. Exchange rates feed into it, but the measures answer different questions.

The Bottom Line

Terms of trade matters most to commodity exporters, whose national income can swing with world prices for oil, metals and farm goods. An improving reading works like a real income gain, but it says nothing alone about trade volumes or the trade balance. Readers should check what caused a change and how the indexes were built before treating a higher TOT as good news.