# Terms of Trade (TOT): Key Indicators and Economic Impacts Explained

## What Are Terms of Trade (TOT)?

Terms of Trade (TOT) serves as an essential indicator of economic health, evaluating the ratio of export to import prices. A favorable TOT indicates a nation earns more from exports than it spends on imports, enhancing economic stability. Understanding TOT can aid in assessing capital flows and economic conditions, vital for policymakers and investors alike.  

### Key Takeaways

*   Terms of trade (TOT) is a vital economic gauge reflecting the ratio of a country’s export prices compared to its import prices.
*   A TOT index over 100% indicates beneficial economic trade conditions for a country, where earnings from exports surpass expenditures on imports.
*   Exchange rates, inflation, and scarcity are key factors influencing a country's TOT and overall economic stability.
*   Improved TOT allows a country to purchase more imports for each unit of export, enhancing its economic position.
*   The Prebisch-Singer hypothesis highlights challenges for developing countries, asserting declining TOT due to falling commodity prices relative to manufactured goods.

![Terms of Trade (TOT)](https://www.investopedia.com/thmb/YqQqaUdyXRh8DganlxqLHVT9gr0=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/Terms_of_Trade_Final-resized-d44980f286714861b8cf8ed0cf9f0841.jpg)

*— Investopedia / Candra Huff*

## Understanding the Economic Impact of Terms of Trade

The TOT is used as an indicator of a country’s economic health, but it can lead analysts to draw the wrong conclusions. Import and export price changes affect TOT, so understanding why they rise or fall is key. TOT is often measured in an [index](https://www.investopedia.com/terms/i/index.asp) for economic monitoring.

An increase in TOT usually means export prices have risen while import prices stayed the same or dropped. Conversely, export prices might have dropped, but not as significantly as import prices. Export prices might remain steady, while import prices have decreased, or they might have simply increased at a faster pace than import prices. All these scenarios can result in an improved TOT.

## Critical Factors Influencing Terms of Trade

TOT is dependent to some extent on exchange and inflation rates and prices. Other factors also influence TOT, and some are unique to specific sectors and industries.  

[Scarcity](https://www.investopedia.com/terms/s/scarcity.asp), or the number of goods available for trade, is one such factor. 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](https://www.investopedia.com/terms/c/capital.asp) obtained from sales.

> **Fast Fact**
>
> The size and quality of goods also affect TOT. Larger and higher-quality goods will likely cost more. When goods sell for a higher price, sellers have more capital to buy more goods.

## Effects of Terms of Trade Fluctuations on Economies

A country can purchase more imported goods for every unit of export that it sells when its TOT improves. A rising TOT is beneficial because it means a country needs fewer exports to buy the same imports.

It might also have a positive impact on domestic [cost-push inflation](https://www.investopedia.com/terms/c/costpushinflation.asp) when the TOT increases because the increase is indicative of falling import prices to export prices. The country’s export volumes could fall to the detriment of the [balance of payments](https://www.investopedia.com/terms/b/bop.asp) (BOP), however.

The country must export a greater number of units to purchase the same number of imports when its TOT deteriorates. The Prebisch-Singer hypothesis suggests that some developing countries have declining TOTs because commodity prices fall compared to manufactured goods.

## Terms of Trade Challenges for Developing Countries

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

Globalization has reduced the prices of manufactured goods. Industrialized countries' advantage over developing countries is becoming less significant.

## How Do You Calculate a Country's Terms of Trade?

Terms of trade for a country can be calculated by dividing its price index of exports by its price index of imports. This ratio is then multiplied by 100:

_TOT = Pexports/Pimports x 100_  

## What Does a Rising Terms of Trade Indicate?

An increasing TOT ratio indicates that a country is exporting relatively more goods than it is importing. Over time, this can lead to a [trade surplus](https://www.investopedia.com/terms/t/trade-surplus.asp). The opposite would be true if TOT were decreasing.

## How Can Terms of Trade Be Improved?

A rise in the domestic currency's exchange rate should improve terms of trade, as this makes imports relatively less expensive while boosting the prices of exports. Increasing the competitiveness of firms will also tend to boost TOT as they can compete better internationally. Inflation can also have a short-term benefit to TOT.

## The Bottom Line

The terms of trade (TOT) serve as a vital indicator of a country's economic health by measuring the ratio of export prices to import prices. A TOT above 100% indicates that a country benefits from its trade, earning more from exports than it spends on imports. Influencing factors such as exchange rates, inflation, and product scarcity play significant roles in TOT fluctuations. Improvements in TOT can strengthen an economy by allowing a country to purchase more imports with fewer exports, while deteriorating TOT can pose challenges, especially for developing nations dealing with volatile commodity prices. Understanding these dynamics offers insights into a country's trading position and economic stability.  

> **Article Sources**
>
> 1.  U.S. Bureau of Labor Statistics. "[Terms of Trade Indexes](https://www.bls.gov/mxp/publications/factsheets/terms-of-trade.htm)."
>     
> 2.  U.S. International Trade Commission. “[Prebisch-Singer Redux](https://www.usitc.gov/publications/332/EC0206A.pdf).” Pages 2-3.
>     
> 3.  World Trade Organization. "[Commodity Terms of Trade: The History of Booms and Busts](https://www.wto.org/english/res_e/publications_e/wtr10_forum_e/wtr10_13july10_e.htm)."
>     
> 4.  SSRN. “[Commodity Terms of Trade: The History of Booms and Busts](https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1486523&download=yes).” Pages 13-15. Download PDF.
>     
> 5.  International Monetary Fund. "[Globalization: a Brief Overview](https://www.imf.org/external/np/exr/ib/2008/pdf/053008.pdf)." Page 1.
>     
> 6.  International Monetary Fund. "[The Distribution of Gains from Globalization](https://www.imf.org/en/Publications/WP/Issues/2018/03/13/The-Distribution-of-Gains-from-Globalization-45722)." Pages 38-39. Download PDF.