Terms of Trade

The terms of trade for a country are the ratio of its export prices to its import prices, expressed as an index relative to a base year. The terms of trade can be calculated using the formula below.

                     export price index
terms of trade   = ----------------------    x 1000
                     import price index

When the terms of trade are 1000, this is the base year for the index from which percentage changes are calculated. If the terms of trade index was 1121 one year relative to a base year, this would mean that in this year, the terms of trade were 12.1% higher than the base year.

An improvement in our terms of trade means a given quantity of our exports will now buy more imports, i.e., the purchasing power of New Zealand (for example) exports has increased. Changes in our terms of trade depend on relative movements of our export prices in import prices. Price changes in terms of trade can be in the opposite direction, the same direction with one increasing or decreasing faster then the other, or one may be stable and the other changing. A numerical decrease in our terms of trade is deemed unfavourabe while a numerical increase is deemed favourable.

The year deemed as most favourable for our terms of trade has the highest index number, while the terms of trade are least favourable in the year with the lowest index number. We have to be careful how we view changes in our terms of trade position in relation to our current account balance. A deterioration in our terms of trade because export prices rise slower than the rise in import prices means the purchasing power of our exports has decreased. A given quantity of exports will now buy fewer imports.

New Zealands's current account balance could improve if the value of export receipts are greater than the value of import payments. What is likey to happen if New Zealand's terms of trade index falls is that the import payments will have increased more than export receipts, and the balance of the current account will have worsened (i.e., produced a larger deficit on the current account balance). There is probably little New Zealand can do to influence its terms of trade, because New Zealand is a small country it must accept the prevailing prices on the world markets.

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