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What are 'Terms of Trade - TOT'?

Terms of trade represent the ratio between a country's export prices and its import prices. The ratio is calculated by dividing the price of the exports by the price of the imports and multiplying the result by 100. When a country’s TOT is less than 100%, more capital is leaving the country than is entering the country. When the TOT is greater than 100%, the country is accumulating more capital from exports than it is spending on imports.

BREAKING DOWN 'Terms of Trade - TOT'

The TOT is used as an indicator of a country’s economic health, but it can lead analysts to draw the wrong conclusions. Changes import and export prices impact the TOT, and it's pertinent to understand what caused the price increases or decreases. TOT measurements are often recorded in an index for economic monitoring purposes.

Factors Affecting Terms of Trade

A variety of factors affect the TOT, and some are unique to specific sectors and industries. Scarcity, or the amount of goods available for trade, is one factor influencing the TOT. The more goods a vendor has available for sale, the more goods it will likely sell, and the more goods that vendor can buy using capital obtained from sales.

For example, during the commodity price boom of the early 2000s, developing countries experienced increases in their terms of trade. When selling a certain quantity of commodities, such as oil and copper, they could buy more consumer goods from other countries.

The size and quality of goods also affect TOT. Larger and higher-quality goods will likely cost more. If goods sell for a higher price, a seller will have additional capital to purchase more goods.

Fluctuating Terms of Trade

When a country’s TOT improves, for every unit of export that a country sells, it can purchase more imported goods. Therefore, an increase in the TOT may be beneficial because the country needs fewer exports to buy a given number of imports. When the TOT increases, it may also have a positive impact on domestic cost-push inflation because the increase is indicative of falling import prices in relation to export prices. However, the country’s export volumes could fall to the detriment of the balance of payments.

When a country’s TOT deteriorates, the country must export a greater number of units to purchase the same number of imports. The Prebisch-Singer hypothesis states that some emerging markets, or developing countries, have experienced declining TOT because of a generalized decline in the price of commodities relative to the price of manufactured goods. In the past two decades, however, a rise in globalization has reduced the price of manufactured goods. Thus, industrialized countries' advantage over developing countries is becoming less significant.

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