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Terms of trade

Terms of trade

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In international economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 and international trade
International trade
International trade is the exchange of capital, goods, and services across international borders or territories. In most countries, such trade represents a significant share of gross domestic product...

, terms of trade or TOT is (Price Exports)/(Price Imports). In layman's terms it means what quantity of imports can be purchased through the sale of a fixed quantity of exports. "Terms of trade" are sometimes used as a proxy for the relative social welfare of a country, but this heuristic is technically questionable and should be used with extreme caution. An improvement in a nation's terms of trade (the increase of the ratio) is good for that country in the sense that it can buy more imports for any given level of exports. The terms of trade is influenced by the exchange rate because a rise in the value of a country's currency lowers the domestic prices for its imports but does not directly affect the commodities it produces (i.e. its exports).

The term


"Terms of trade" takes a plural form. However, it is a single number that represents the ratio of the relative prices.

Two country model CIE economics


In the simplified case of two countries and two commodities, terms of trade is defined as the ratio of the total export revenue a country receives for its export commodity to the total import revenue it pays for its import commodity. In this case the imports of one country are the exports of the other country. For example, if a country exports 50 dollars worth of product in exchange for 100 dollars worth of imported product, that country's terms of trade are 50/100 = 0.5. The terms of trade for the other country must be the reciprocal (100/50 = 2). When this number is falling, the country is said to have "deteriorating terms of trade". If multiplied by 100, these calculations can be expressed as a percentage (50% and 200% respectively). If a country's terms of trade fall from say 100% to 70% (from 1.0 to 0.7), it has experienced a 30% deterioration in its terms of trade. When doing longitudinal (time series) calculations, it is common to set a value for the base year to make interpretation of the results easier.

In basic Microeconomics, the terms of trade are usually set in the interval between the opportunity costs for the production of a given good of two countries.

Terms of trade is the ratio of a country's export price index to its import price index, multiplied by 100
The terms of trade measures the rate of exchange of one good or service for another when two countries trade with each

Multi-commodity multi-country model


In the more realistic case of many products exchanged between many countries, terms of trade can be calculated using a Laspeyres index. In this case, a nation's terms of trade is the ratio of the Laspeyre price index of exports to the Laspeyre price index of imports. The Laspeyre export index is the current value of the base period exports divided by the base period value of the base period exports. Similarly, the Laspeyres import index is the current value of the base period imports divided by the base period value of the base period imports.



Where
price of exports in the current period
quantity of exports in the base period
price of exports in the base period
price of imports in the current period
quantity of imports in the base period
price of imports in the base period

Basically:
Export Price Over Import price times 100
If the percentage is over 100% then your economy is doing well (Capital Accumulation).
If the percentage is under 100% then your economy is not going well (More money going out than coming in).

Limitations


Terms of trade should not be used as synonymous with social welfare, or even Pareto economic welfare
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

. Terms of trade calculations do not tell us about the volume of the countries' exports, only relative changes between countries. To understand how a country's social utility
Utility
In economics, utility is a measure of customer satisfaction, referring to the total satisfaction received by a consumer from consuming a good or service....

changes, it is necessary to consider changes in the volume of trade, changes in productivity and resource allocation, and changes in capital flows.

The price of exports from a country can be heavily influenced by the value of its currency, which can in turn be heavily influenced by the interest rate in that country. If the value of currency of a particular country is increased due to an increase in interest rate one can expect the terms of trade to improve. However this may not necessarily mean an improved standard of living for the country since an increase in the price of exports perceived by other nations will result in a lower volume of exports. As a result, exporters in the country may actually be struggling to sell their goods in the international market even though they are enjoying a (supposedly) high price.

In the real world of over 200 nations trading hundreds of thousands of products, terms of trade calculations can get very complex. Thus, the possibility of errors is significant.