Measured by calculating the weighted average of export prices over the weighted average of import prices and multiplying by 100
Calculating terms of trade
1. Formulate a basket of most popular exports and weight by revenue
2. Formulate a basket of most popular imports and weight by expenditure
3. Divide the price of the export basket by the price of the import basket
4. Multiply by 100 to get the index
Terms of trade index
Compares the current terms of trade to a base year (set at 100)
An improvement in the terms of trade means the basket of exports can buy more imports than before
A deterioration in the terms of trade means the basket of exports can buy fewer imports than before
Short-run factors affecting terms of trade
Changes in demand and supply for exports and imports
Changes in supply conditions like weather
Relative inflation rates
Changes in exchange rates
Long-run factors affecting terms of trade
Changes in global income patterns
Productivity and technology changes
Developing countries often experience a long-term deterioration in terms of trade as demand for their primary commodity exports rises less than demand for manufactured imports
Improvements in productivity and technology can lead to a deterioration in terms of trade, but this is often outweighed by increased competitiveness
