Terms of Trade (TOT): Definition, Use as Indicator, and Factors

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What Are Terms of Trade (TOT)?

Terms of trade (TOT) represent the ratio between a country's export prices and its import prices. TOT indexes are defined as the value of a country's total exports minus total imports. The ratio is calculated by dividing the price of the exports by the price of the imports and multiplying the result by 100.

When more capital is leaving the country than is entering the country, then the TOT will be less than 100%. When the TOT is greater than 100%, the country is accumulating more capital from exports than it is spending on imports. In the United States, the ebb and flow of value of trade activity is tracked by the Import/Export Price Index (MXP).

Key Takeaways

• Terms of trade (TOT) is a key economic metric of a country's health measured through what it imports and exports.
• TOT is expressed as a ratio that reflects the number of units of exports that are needed to buy a single unit of imports.
• TOT is determined by dividing the price of the exports by the price of the imports and multiplying the number by 100.
• A TOT over 100% or that shows improvement over time can be a positive economic indicator as it can mean that export prices have risen as import prices have held steady or declined.

Understanding Terms of Trade (TOT)

The TOT is used as an indicator of a country’s economic health, but it can lead analysts to draw the wrong conclusions. Changes in import prices and export prices impact the TOT, and it's important to understand the specific causes underlying price increases or decreases. TOT measurements are often recorded in an index for economic monitoring purposes.

An improvement or increase in a country's TOT generally indicates that export prices have gone up as import prices have either maintained or dropped. Conversely, export prices might have dropped but not as significantly as import prices. Export prices might remain steady while import prices have decreased or they might have simply increased at a faster pace than import prices. All these scenarios can result in an improved TOT.

Factors Affecting Terms of Trade

TOT is dependent to some extent on exchange and inflation rates and prices. A variety of other factors influence TOT as well, and some are unique to specific sectors and industries.

Scarcity—the number of goods available for trade—is one such factor. The more goods a vendor has available for sale, the more goods it will likely sell, and the more goods that vendor can buy using capital obtained from sales.

The size and quality of goods also affect TOT. Larger and higher-quality goods will likely cost more. If goods sell for a higher price, a seller will have additional capital to purchase more goods.

Fluctuating Terms of Trade

A country can purchase more imported goods for every unit of export that it sells when its TOT improves. An increase in the TOT can thus be beneficial because the country needs fewer exports to buy a given number of imports.

It might also have a positive impact on domestic cost-push inflation when the TOT increases because the increase is indicative of falling import prices to export prices. The country’s export volumes could fall to the detriment of the balance of payments (BOP), however.

The country must export a greater number of units to purchase the same number of imports when its TOT deteriorates. The Prebisch-Singer hypothesis states that some emerging markets and developing countries have experienced declining TOTs because of a generalized decline in the price of commodities relative to the price of manufactured goods.

TOT Example

Developing countries experienced increases in their terms of trade during the commodity price boom in the early 2000s. They could buy more consumer goods from other countries when selling a certain quantity of commodities, such as oil and copper.

A rise in globalization, however, has reduced the price of manufactured goods. Industrialized countries' advantage over developing countries is becoming less significant.

How Do You Calculate a Country's Terms of Trade?

Terms of trade for a country can be calculated by dividing its price index of exports by its price index of imports. This ratio is then multiplied by 100:

What Does a Rising Terms of Trade Indicate?

An increasing TOT ratio indicates that a country is exporting relatively more goods than it is importing. Over time, this can lead to a trade surplus. The opposite would be true if TOT were decreasing.

How Can Terms of Trade Be Improved?

A rise in the domestic currency's exchange rate should improve terms of trade, as this makes imports relatively less expensive while boosting the prices of exports. Increasing the competitiveness of firms will also tend to boost TOT as they can compete better internationally. Inflation can also have a short-term benefit to TOT.