In general terms, the terms of trade refer to the quantity of goods sold and purchased at a given price. In the field of international trade, ‘terms of trade’ refer to the rate at which country’s exports exchange for its imports. Naturally, the prices of the commodities to be exported and imported influence the exports and imports of the two countries. They indicate the relationship between the prices of exports and imports of a country.
The terms of trade can be calculated with the help of the following formula —
PX/PM x 100
— PX1 and PM1 refer to the prices of exports and imports respectively in a subsequent period.
— PX0 and PM0 refer to the prices of exports and imports respectively in the base period.
—PX refers to the index number of exports.
—PM refers to the index number of imports.
Suppose, in the current year, the index number of exports has gone up by 40 percent and that of imports by 60 percent, the terms of trade can be calculated as follows—
(PX/PM) x 100
Or [Export Index/Import Index] x 100, Or
It implies that our export has follow by 12.5% as compared to our imports. If the terms of trade fall below 100, they are taken as unfavorable and if they go up above 100 means they are favorable. In other words, if prices of exports are high relatively to the prices of imports, the terms of trade are said to favorable or if the prices of imports are high relatively to the prices of its exports, the terms of trade are considered to be unfavorable.
Generally, the terms of trade depend upon the ‘reciprocal demand‘ for goods i.e. the demand and supply of one country’s goods in the other country and other country’s goods in this country due to change in prices.