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Theories

Terms of Trade

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The value of a country's exports and imports, and consequently the flows of money into and out of a country that are recorded in it balance of payments, is determined by the quantity of the good or service traded and their prices.

Changes in the relative prices of exports and imports are important factors in influencing the values of exports and imports and the balance of payments of a country. The terms of trade is a measure of the relative prices of imports and exports.

The coefficient of income elasticity can be calculated by the following formula

If the terms of trade index number increases (DPx>DPm) it is described as a favourable movement (a unit of exports will buy more imports).

If the terms of trade index number decreases (DPx<DPm) it is described as a worsening or deterioration of the terms of trade (a unit of exports will buy fewer imports).

This terminology is somewhat ambiguous as it is important to bear in mind that a favourable or worsening of a countries terms of trade does not necessarily mean that anything is better or worse in term of the balance of payments situation. Both the price and the quantity of goods traded must be taken into account when considering the balance of payments situation.

An increase or favourable change in the Terms of Trade index caused by an increase in the price of exports may bring about a proportionately greater fall in the demand for exports leading to a worsening of the balance of payments situation. Conversely, a worsening of the terms of trade index caused by a fall in export prices may lead to a proportionately greater increase in the demand for exports and an improvement in the balance of payments.

It is important to consider how responsive the quantity demanded is to changes in the price of exports and imports. The price elasticity of demand is thus crucial.

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Related Glossary Items:
Price Elasticity of Demand
Terms of Trade
Balance of Payments
Balance of Trade
Current Account

Related Issues:
Zambia's Exports and Imports
Zambia's Balance of Payments Situation

Related Theories:
Price Elasticity of Demand