The Terms of Trade

What are the terms of trade?

The terms of trade measures the rate of exchange of one good or service for another when
two countries trade with each other.
For trade between nations to be mutually beneficial, the terms of trade must lay within the
opportunity cost ratios for both countries.
How are the terms of trade calculated?
We calculate the terms of trade as an index number using the following formula:
Terms of Trade Index (ToT) = 100 x Average export price index / Average import price index

If export prices are rising faster than import prices, the terms of trade index will improve. This
means that fewer exports have to be given up in exchange for a given volume of imports. If
import prices rise faster than export prices, the terms of trade have deteriorated. A greater
volume of exports has to be sold to finance a given amount of imported goods and services.
The terms of trade fluctuate in line with changes in export and import prices. Clearly the
exchange rate and the rate of inflation can both influence the direction of any change in the
terms of trade.
The terms of trade for a country will improve if:
1. Their export prices in overseas markets increase meaning that each unit sold brings
higher revenue. A good example of this was the recent surge in food, oil and gas
prices for countries that are net exporters of these products. The oil-exporting nations
saw a sharp improvement in their terms of trade because every barrel of oil was
worth more. As a result there was a steep improvement in their short-term balance of
payments. The annual value of their oil exports surged from $110bn in 2004 to over
$275 in 2008.
World Oil Price and Saudi Oil Exports
Crude Oil (OPEC reference price), Saudi Oil Exports $billion
100 100
90 90
80 80
USD/Barrel

70 70
60 60
50 50
40 40
30 30
20 20
10 10

300 300
275 275
250 250
225 225
USD (billions)

200 200
billions

175 175
150 150
125 125
100 100
75 75
50 50
01 02 03 04 05 06 07 08

World, Energy, Oil, OPEC Reference Basket Price, Fixing

Saudi Arabia, Current Account, Goods, Oil exports (excluding bunker oil)
Source: Reuters EcoWin
 2. Their import prices fall. Consider for example a country that is reliant on importing raw
materials and component parts for manufacturing in the domestic economy. If these
inputs become cheaper, domestic businesses will experience a fall in variable costs and
improved terms of trade.
South Africa Terms of Trade
Terms of Trade, Index, 2000=100
130 130

125 125

120 120

115 115
Index

110 110

105 105

100 100

95 95
00 01 02 03 04 05 06 07 08 09

Total, excluding gold Total, including gold

Source: Reuters EcoWin

Here is an example of a country whose terms of trade have improved in recent years – South
Africa. Partly this is the result of a surging world price for gold – one of its key exports. But
South Africa is also an exporter of many other minerals.
The Pattern of UK Trade
In an age of globalisation, it is inevitable that,
over time, the pattern of trade in goods and
services changes, reflecting shifts in
comparative advantage and movements in
prices of traded products in international
markets.
The pattern of trade is also affected by the
growth and development of particular
countries or regions and by foreign
investment decisions of UK and overseas
companies. The rapid growth of many
emerging market countries is causing pivotal
changes in the patterns of global trade and investment; the UK economy is deeply affected
by this.
Key trade data for the UK
Trade to GDP ratio (2005-2007) 57.6%
Share of world exports of goods 3.1%
Share of world exports of services 8.3%

Pattern of exports of goods

• Agricultural products 6.3%
• Fuels and mining products 14.8%
• Manufactures 74.1%

Main export markets:

• European Union 57%
• United States: 15%
• Switzerland: 2%
• China: 2%
• Japan: 2%

Main source of imports:

• European Union 55%
• USA: 9%
• China: 8%
• Norway: 5%
• Japan: 3%
Source: Trade Profile for the UK, World Trade Organisation

• The majority of UK trade is with twenty-six partner countries in the European Union.
There has been a long-term shift in our trade with EU since the UK joined in 1973. The
enlargement of the Single Market that has led to trade creation and trade diversion
effects has encouraged the growth of trade.
• The share of UK trade with North American countries has declined, but the United
States remains the largest single export market accounting for 15% of UK exports.
Trade with oil exporting countries has fallen in relative importance over the last fifteen
years In 1979, 10% of UK exports went to oil exporting countries, this has now
declined to just over 3% as has the share of imports from these countries.
• The other significant change in the geographical pattern of trade for the UK is an
increasing share of trade with emerging economies in Asia including China,
Singapore, Malaysia, South Korea, Taiwan and Thailand and also now with fast-
growing countries in the Indian Sub-Continent.