An important statistic in the economics of international trade concerns the “terms of trade”. The terms of trade are the ratio between export prices and import prices. In other words, the terms of trade are a relative price that tells us how many imports we can buy per dollar of exports. A country’s terms of trade improve (become higher) when export prices rise relative to import prices; people can now buy more imports from abroad while forgoing fewer exports. Conversely, a country’s terms of trade decrease (become smaller) when the price of imports increases relative to the price of exports; people have to pay more in exports to import the same value of imports.
For example, let’s say we have two countries: Whitebreak and Faltera. Whitebreak exports wheat and imports art (and vice versa for Faltera). Wheat sells for $1 and artwork for $1. The terms of trade in this initial state are 1. Now suppose the price of wheat doubles to $2. Whitebreak’s terms of trade improve to 2 ($2 for wheat/$1 for art). By selling the same amount of wheat, you can now buy 2 works of art. The terms of trade in Whitebreak have improved. Conversely, Faltera must now give up two works of art to purchase the same amount of wheat.
The terms of trade have improved for Whitebreak, but residents Improved Whitebreak? It can be tempting to say, “Yes!” They can buy more with the same amount of resources. Of course they are better off! As readers from the title of this article have probably already inferred, this answer is incorrect. For what The changed prices tell us more about whether Whitebreak residents are better off or not. As Scott Sumner would saynever reason about a price change.
There are two reasons why the price of a good can change: a change in request for this good or a change provide. If demand increases and the price of wheat increases, the people of Whitebreak are better off: the amount of wheat consumed worldwide increases and the economic surplus generated in the wheat market increases. Additionally, as Falterians buy more, they sell more art in Whitebreak, allowing Whitebreak residents to benefit from more decorations for their homes. In this case, the increase in terms of trade is correlated with Whitebreak doing better. Note that the Falterans are also better off even though their terms of trade have decreased because they are increasing consumption of the goods they want.
But let’s say that, rather than an increase in demand for Whitebreakian wheat, there is a blight decimating the crop. This reduction in supply would lead to an increase in the price of wheat. Again, this increase in the price of wheat would improve Whitebreak’s terms of trade with Faltera, but in this case the people of Whitebreak are certainly worse off: they have less wheat to consume (and, therefore, less wheat to exchange for art). Their economic well-being deteriorates. In this case, the improvement in the terms of trade does not not report an improvement in the standard of living of Whitebreakians.
In real life, both the price of exports and imports are constantly changing. Since the terms of trade are a ratio, they can also change depending on the percentage change in prices. For example, let’s say there is a recession and prices of Whitebreak wheat and Faltera art fall due to reduced demand. Since art is a luxury good, the decline will probably be greater for works of art than for wheat. If, for example, wheat prices fall by 3% but art prices fall by 20%, the terms of trade will improve. Again, this improvement is misleading when it comes to the well-being of Whitebreakians and Falterans.
Understanding this limitation of the terms of trade, or any statistic, is important when discussing trade policy. Judging the success or failure of a policy using a single (or even a set of) indicators can lead to flawed reasoning if one does not understand the underlying data that influences the indicator.
None of this means we should abandon the terms of trade. This is a useful statistic. But like any statistic, we must be careful in its use and interpretation. Ultimately, the answer to the question of whether an improvement (or deterioration) in the terms of trade is a good or bad thing is: “it depends.”
Jon Murphy is an assistant professor of economics at Nicholls State University.
