Terms of Trade - TOT

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What are 'Terms of Trade - TOT'?

Terms of trade (TOT) represent the ratio between the export prices of a country and the 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; however, it can lead analysts to draw the wrong conclusions. The TOT is impacted by changes in the prices of exports and imports, and the underlying causes of an increase or decrease in prices are pertinent. 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 greater the amount of goods available for sale, the more a vendor is likely to 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 are also factors that affect TOT. The larger the size of a good, or the higher the quality of the good, the more costly it is likely to be. If goods sell for a higher price, in turn, a seller can purchase a greater amount of goods.

Fluctuating Terms of Trade

When a country’s TOT improves, for every unit of export that a country sells, it can purchase more units of imported goods. Therefore, an increase in the TOT may be beneficial because fewer exports are required to buy a given amount of imports. When the TOT increases, it may also have a positive effect 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 given 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, the advantage that industrialized countries have over developing countries is becoming less significant.