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How to Calculate Terms of Trade? | Economics

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The following article will guide you about how to calculate terms of trade.

The rate at which one country’s products exchange for those of another is known as the term of trade. If the terms of trade move in a nation’s favour, it gets a larger quantity of imports for a given quantity of its exports. This happens because import prices fall relative to export prices.

For exam­ple, if in a certain year India can import 10 tonnes of steel in exchange for the export of one Maruti car, and in the following year 15 tonnes of steel in exchange for the same car its terms of trade will improve. If, on the other hand, 2 cars had to be exported in exchange for 10 tonnes of steel in the second year, then the terms of trade would have moved against India.

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The terms of trade depend on the world prices of commodities entering into international trade. Fluctuations in the terms of trade are likely to have an effect on the standard of living of a country which has a high level of imports and exports.

Thus, when the terms of trade are favourable, a trading nation can enjoy a higher standard of living. This is because which import prices fall a larger quantity of goods can be imported in exchange for the same quantity of exports.

The terms of trade are calculated by using the following formula:

Index of Export Prices/Index of Import Prices × 100 = Terms of Trade Index

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Let us consider a simple example. If the index rises, then it will indicate a trend favourable to India. For example, assuming the index of export prices changes to 120 and the index of import prices to 60.

Then (120/60) × 100 = 200, which means that India’s exports are exchanged for twice as many imports as in the base year, when the Index was 100. On the other hand, a fall in the terms of trade index indicates an unfavourable trend. This is because the prices of imports will have risen faster to that of exports.

Determination of Terms of Trade:

It may be noted that the greater the divergence between the international terms of trade and the exchange ratio that would prevail within a country if it didn’t trade, the greater the gain in real income that this country can achieve through trade.

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The point at which a country’s terms of trade settle depends on the strength of domestic demand for the goods it imports relative to foreign demand for the goods it exports. The stronger a country’s demand for imports, the higher the price it will have to pay for them, and the less favourable its terms of trade. The stronger the foreign demand for a coun­try’s exports, the higher the price it will get for them, and the more favour­able in terms of trade.

It is obvious that the terms of trade would change with the change in reciprocal demand, which primarily depends on the world prices of com­modities entering into international trade. A change in such prices, would also bring about a change in the terms of trade.

Importance:

The terms of trade have much significance in not only international transactions but also in the overall economic sphere of a country. An unfavourable terms of trade reduce the gains from international trade. A country then would be required to export a larger quantity of its products than before for importing the same quantity of goods.

Besides, a fall in the international demand for the commodity of a country (e.g., decline in the world demand for jute goods) would reduce, revenue of the jute industry, causing a fall in the earning of jute workers with its repercussions on other industries as well.

A favourable terms of trade, on the other hand, is likely to increase the exports of a country, causing a rise in the income-level of the people. For this reason it is said that the real income per capita of a country depends mainly on its output per head and partly on its terms of trade.

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