The terms of trade of a nation are defined as the ratio of the price of its exports to the price of its imports. Since in a two-nation world, the exports of a nation are the imports of its trade partner, the terms of trade of the latter are equal to the inverse, or reciprocal, of the terms of trade of the former.

In a world of many (rather than just two) traded commodities, the terms of trade of a nation are given by the ratio of the price index of its exports to the price index of its imports. This ratio is usually multiplied by 100 in order to express the terms of trade in percentages. These terms of trade are often referred to as the commodity or net barter terms of trade to distinguish them from various other measures of the terms of trade.

An improvement in a nation’s terms of trade is usually regarded as good for the nation in the sense that the prices that the nation receives for its exports rise relative to the prices that it pays for imports.

Illustration of the Terms of Trade:

If country 1 exports commodity X and imports commodity Y, its terms of trade are given by Px/Py. If it exported and imported many commodities, Px would be the index of its export prices, and Py would be the index of its import prices.

If country 2 exports commodity Y and imports commodity X, its terms of trade are given by Py/Px. This is the inverse, or reciprocal, of l’s terms of trade and also equals 1 or 100 (in percentages) in this case.

If through time the terms of trade of country 1 rose, say, from 100 to 120, this would mean that country l’s export prices rose 20% in relation to its import prices. This would also mean that country 2 is terms of trade have deteriorated from 100 to (100/120)100 = 83. We can always set a nation’s terms of trade equal to 100 in the base period, so that changes in its terms of trade over time can be measured in percentages.

Even if country l’s terms of trade improve over time, we cannot conclude that country 1 is necessarily better of because of this, or that country 2 is necessarily worse off because of the deterioration in its terms of trade.

Changes in a country’s terms of trade are the result of many forces at work both in that nation and in the rest of the world, and we cannot determine their new effect on a nation’s welfare by simply looking at the change in the country’s terms of trade.

There are various types of terms of trade. These are the income terms of trade, the single factoral terms of trade and the double factoral terms of trade. The commodity, or net barter, terms of trade (N) is the ratio of the price index of the country’s exports (Px), to the price index of its imports (Pm), multiplied by 100 (to express the terms of trade in percentages).

That is:

N = (Px/Pm) 100 … (1)

For example, if we take 1980 as the base year (N-100), and we find that by the end of 1998, the nation’s Px fell by 5% (to 95), while its Pm rose by 10% (to 110), then this country’s commodity terms of trade declined to

N = (95/110) 100 = 86.36

This means that between 1980 and 1998 the nation’s export prices feel by 14% in relation to its import prices.

A nation’s income terms of trade (I) are given by:

I = (Px/Pm) Qx … (2)

where Qx is an index of the volume of exports. Thus, I measures the country’s export-based capacity to import. In our example, if Qx rose from 100 in 1980 to 120 in 1998, then the country’s income terms of trade rose to

I = (95/110)120 = (0.8636) (12) = 103.63

This means that from 1980 to 1998 the country’s capacity to import (based on its export earnings) increased by 3.63% (even though Px/Pm declined). The change in the income terms of trade is very important for developing nations, since they rely to a large extent on imported capital goods for their development.

A nation’s single factoral terms of trade (S) are given by:

S = (Px/Pm) Zx … (3)

where Zx is a productivity index in the country’s export sector. Thus, S measures the amount of imports the nation gets per unit of domestic factors of production included in its exports.

For example, if productivity in the country’s export sector rose from 100 in 1980 to 130 in 1998 then the country’s single factoral terms of trade increased to:

S = (95/110)130 = (0.8636) (130) = 112.27

This means that in 1998 the nation received 12.27% more imports per unit of domestic factors embodied in its exports than it did in 1980. Even though the nation shares part of its productivity increase in its export sector with other nations, the nation was better off in 1998 than it was in 1980 (by more than indicated by the increase in/and even though N declined).

The concept of the single factoral terms of trade can be extended to measure the country’s double factoral terms of trade (D), given by

D = (Px/Pm) Zx/Zm) 100 … (4)