The Terms of Trade measures the relative price of exports compared to the price of imports.
Terms of Trade = 100 * Average export prices / Average
Import prices.
Basically,
the terms of trade refers to how many exports will need to be sold in order to
be able to purchase imports.
i) If the
price of exports increases, there will be an improvement in the terms of trade.
ii) If
the price of exports falls, there will be a decline in the terms of trade.
Importance of the terms of Trade: To some
extent we can use the terms of trade to measure the strength and well-being of
an economy. A prolonged fall in the terms of trade will reduce living
standards. The US, will find that it can increasingly purchase less imports
from abroad. But, at the same time it is also quite limited. For example, devaluation
doesn’t necessarily harm a country. Devaluation does make exports more
competitive and can increase economic growth.
There is much more to the strength of an economy than the terms of trade. For
example:
v
Volumes
of trade
v
productivity
v
capital
flows
v
economic
growth