International Trade – Definition Of Terms Of Trade

International trade is constantly evolving and with it economic concepts. Terms of trade is one such concept that is important for foreign trade.

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Definition

It is a measure of the ratio in which the exports of one country are exchanged for the exports of another country, and thus an indicator showing their mutual competitiveness.

The most commonly used versions of this indicator are:

• Goods TOT –It is the price of the exported good expressed in units of the imported good. In practice, it is calculated as the ratio of the export price index to the import price index.
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  Where:

the export price index is Pex

the import price index is Pim

When the index is greater than 100, it means that export prices are growing faster than import prices, while the index lower than 100 indicates the opposite relationship. The higher this index is, the more favorable price relations occur in foreign trade .

• Volume TOT- the ratio of the amount of imports to the amount of exports. You can calculate this indicator as follows.
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  Where:

import volume is Qim

export volume is Qex

The higher the ratio, the more goods the country receives for the goods it exports .

• Profitable TOT - It is the product of commodity terms of trade and export volume. This indicator informs about the volume of imports that can be financed with current export proceeds. We calculate profitable terms of trade
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  The higher the profitable terms of trade , the greater the purchasing power of exports. This indicator measures the benefits of trade better than the price index when the terms of trade change under the influence of economic growth.

Simplified model of two countries

In order to explain what the terms of trade are all about , we can in a simplified case adopt a model in which we have two countries and two trade goods. We then define the terms of trade as the ratio of the total proceeds from the sale of goods exported by country A to country B to the total cost of importing goods from country B. In this simplified model, for each individual good, exports for one country equal the value of imports for country B. Assuming specific values, let's assume that country A exported goods worth USD 5 million to country B, while importing goods worth USD 10 million, the terms of trade indicatorcalculated on the basis of the above formulas will be 0.5. As mentioned, the export of one country is the import of another, which means that the terms are mutual and it will be the inverse terms of trade for country A, which in our case gives us a value of 2. When this number decreases, i.e. the country starts buying more than selling, we talk about worsening of the terms of trade (trade balance). Results can also be expressed as a percentage here 50% and 200% respectively. With percentages that are easy to communicate about changes, a drop from 100% to 80% will mean a 20% deterioration in trading conditions

Limitations

The price of a country's exports can be very strongly dependent on the value of its currency, which is strongly influenced by the level of interest rates. If the value of the currency of individual countries increases by raising interest rates, we can expect an improvement in terms of trade. However, this does not necessarily mean an improvement in the standard of living, because the increase in export prices noticed by other countries leads to a decrease in the volume of exports. The benefit of this arrangement is creating an environment for companies to compete on the international arena and allowing them to fight for salesof their products despite the relatively high price. Unlike the model, in the real world we are able to estimate quantities based on research. Currently, over 200 countries are involved in international trade, offering millions of different products. Due to such huge quantities and complexity of calculations , the risk of obtaining results deviating from the real values is significant.

Source: Backus, David, Patrick J. Kehoe, and Finn E. Kydland. (1992) Dynamics of the Trade Balance and the Terms of Trade: The S-curve, Bożek P., Misala J., Puławski M. (1998) International Economic Relations