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 rise. 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.

How their fluctuations may affect the trade balance:

An improvement in the terms of trade mean that export prices are increasing faster than import price. Therefore there will be a fall in exports and an increase in quantity of imports. Therefore, it is likely that with lower exports the current account deficit (+ trade deficit) will get worse i.e. bigger deficit

However, it relies on the Marshall Lerner Condition. If the Marshall Lerner condition is satisfied then an improvement in the terms of trade will worsen the current account.

The Marshall Lerner condition states that if demand for exports and imports is relatively elastic PED x + PED m >1 then an increase in terms of trade will worsen the current account (balance of trade)

Sometimes elasticity of demand varies over time. In the short term demand is often inelastic, in the longer term demand becomes more elastic. Therefore, we can often see a J Curve effect, where an improvement in terms of trade worsens current account in short term but improves in long term.