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Meaning and Definition:

By terms of trade (TOT), is meant terms or rates at which the products of one country are exchanged for the products of the other. It is known to us that every country has got its own money. The currency of one country is not legal tender in the other country. So every country has to export commodities in order to import goods.

“The rate at which given volume of exports is exchanged for a given quantity of imports is called the commodity terms of trade (TOT)“.

The rate of exchange or the term of exchange depends upon the elasticities of the demand of each country for the products of the other.

For example, if Pakistan’s demand for Indian’s wheat is much more intense than Indian’s demand for Pakistan’s cotton, the terms of trade will be more favorable to India than to Pakistan. This is because Pakistan’s demand for India’s wheat is highly inelastic while India’s demand for Pakistan’s cotton is highly elastic.

The country which is more eager to sell or purchase stands at disadvantage in the bargain. In the words of Taussing:

“That country gains more from international trade whose exports are more in demand and which itself has little demand for the things it imports, i.e., for the exports of the other countries, that country gains least which has the most insistent demand for the products of the other country”.

That terms of trade are measured by the ratio of import prices to export prices. The terms of trade will be favorable to a country when the export prices are high relatively to import prices. This is because the products of one unit of domestic resources will exchange against the product of more than one unit of foreign exchange. If, on the other hand, the prices of its imports rise relatively to the prices of its exports, the terms of trade will be unfavorable to the country.

Equation or Formula:

The terms of trade (TOT) can be expressed in the form of following equation or formula as such:

The terms of trade are very important and have economic significance to a country. If they are favorable to a country, it will be gaining more from international trade and if they are unfavorable, the loss will be occurring to it. When the country’s goods are in high demand from abroad, i.e., when its terms of trade are favorable, the level of money income increases. Conversely, when the terms of trade are unfavorable, the level of money income falls.

Measurement of TOT:

The changes in terms of trade can be measured by the use of an import and export index number. We here take only standardized goods which have internal market and give them weight according to their importance in the international transactions. A certain year is taken as base year and the average of the countries import and export prices of the base year is called 100. We then work out the index of subsequent year. These indices then show as to how the commodity terms of trade move between two countries.

The ratio of exchange in export prices to the change in import prices is put in the form of an equation as under:

Algebraically, it can be expressed:

Here:

Te Represents commodity terms of trade.

Px1 Represents export price index for the required year.

Px° Represents exports price index of the base year.

Pm1 Represents indices of prices of the required year.

Pm° Represents indices of prices for the base year.

We now apply the above formula by taking a specific example. We take the indices of export and import prices for the year 1982 as 100. We assume also that the export prices index for the year 1982 is 330 and import prices index 380. The ratio of change in export prices to the change in import prices will be:

The above example shows that the prices of imports have increased more than the exports prices. The terms of trade are unfavorable to the country by 13%. In other words, the country has to pay 13% more for a given amount of imports.

Factors Determining Income from Terms of Trade:

It is the desire of every country that it should earn the maximum of income out of international exchange by taking permanent favorable terms of trade. In order to secure maximum gain, the country will try to increase the volume and value of exports and reduce the volume of imports and buy it also from the cheapest market. If the country is having a monopoly in the supply of a commodity and the demand for products is inelastic, then it can fetch more income. In case the terms of trade move against the country, then there will be drain of national income, the commodity terms of trade depend upon the following factors:

(i) Ratio of import prices to export prices.

(ii) The volume and value of exports and imports.

(iii) The condition attached to export and import such as insurance charges, supply of machinery and shipping, etc.

If the terms of trade (TOT) are favorable which may be due to monopolistic supply or inelastic demand or cheap and better kind of exports, etc., the terms of trade will be favorable and the national income will rise. In case of terms of trade are unfavorable over a period of time, the national income will fall.