The terms of trade measures the value of a unit of exports in terms of the number of imports it can buy, or the purchasing power of our exports.
T.O.T= Export Price Index/Import Price index x 1000(base year)
An increase in trade of terms is considered favourable
A decrease in trade of terms is considered unfavourable
A favourable or an increase in the terms of trade may occur because: -the average export price increases and the import price stays the same or average export price increases faster than import price increases. Also, it may occur when the average export prices stays the same but import prices fall or average export prices fall but import prices fall faster.
An improvement in terms of trade gives benefits, for example, the country can buy more imports for any given level of exports. Higher exports than imports mean more surplus or less deficit in current account, and less imports may mean more demand for domestic products and may provide jobs for domestic workers improving the economy. In addition, an increase in terms of trade may also results in a rise in standard living. Furthermore, the effect of an improvement in terms of trade can be changed by the price elasticity of demand because if the goods have inelastic demand, then the net revenue increase while elastic demand will worsen the situation. Also, However, if the export price or the currency rate keeps rising, then the trading partners may not be willing to import the goods anymore from the country or may retaliate by increasing their export price, therefore, the country may face a decrease in the balance of trade. Thus, we can see that an improvement in a country’s terms of trade does not always works to its benefits.