International Trade
Senior 6 · Economics
International Trade
Lesson 3 of 5
25 min
Selling abroad is only half of trade: what matters is how many imports your exports can buy. The World Bank publishes an index that tracks exactly that. The graph shows Rwanda's index from 2015, the base year, to 2024.
Read the graph. (1) In which year was the index highest? (2) By what percentage did it change between 2023 and 2024? (3) What might cause such a jump in one year?
Definition
Terms of trade (ToT): the rate at which a country's exports exchange for its imports, measured by comparing the average price of its exports with the average price of its imports.
Example: if export prices rise while import prices stay the same, each unit of exports buys more imports: the terms of trade have improved.
Definition
Net barter terms of trade: an index number found by dividing an index of export prices by an index of import prices, times 100.
where is the index of export prices and the index of import prices, both equal to 100 in the base year.
A rise in the index is an improvement (a favourable movement); a fall is a deterioration (an unfavourable movement).
Worked example 1: calculating and interpreting the index
In the base year both price indices are 100. Four years later the export price index is 110 and the import price index is 125.
The index has fallen from 100 to 88, a deterioration of 12%. Each unit of exports now buys 12% fewer imports than in the base year, even though export prices themselves went up: import prices rose faster.
Rwanda's own index: between 2023 and 2024 it rose from 114.8 to 129.9, an improvement of
Worked example
Worked example 2: from prices to the index (illustrative)
A country exports only coffee and imports only fuel. Between year 1 (the base) and year 2 the price of coffee rises from US$4.00 to US$5.00 per kg, and the price of fuel from US$1.00 to US$1.10 per litre.
Step 1: price indices.
Step 2: terms of trade.
The terms of trade have improved by about 13.6%: a kilogram of coffee now buys litres of fuel instead of litres.
Definition
Income terms of trade: a measure of a country's capacity to import, which also takes the volume of exports into account.
where is the index of the volume of exports.
Example: with , and , the income terms of trade are : the net barter terms of trade worsened to 90, but because the country sold 30% more, it could buy 17% more imports.
In the last lesson Rwanda and Tanzania traded coffee for maize at 1 tonne of coffee for 2 tonnes of maize. Why that rate? At home, a tonne of coffee costs Rwanda 1.5 tonnes of maize and costs Tanzania 3 tonnes. Rwanda will only export coffee if it gets more than 1.5 tonnes of maize for it (otherwise it could make the maize itself), and Tanzania will only import coffee if it pays less than 3 tonnes of maize (otherwise it could make the coffee itself). So:
Where inside this range the rate settles depends on each country's demand for the other's good. The closer the rate is to 3, the bigger Rwanda's share of the gain; the closer to 1.5, the bigger Tanzania's.
| Cause | Effect on the terms of trade |
|---|---|
| World demand for the country's exports rises (a boom in buyers' economies), or a poor harvest elsewhere cuts world supply | Export prices rise: improvement |
| World prices of imports such as fuel or food rise | Import prices rise: deterioration |
| Faster inflation at home than abroad (with a fixed exchange rate) | Export prices rise relative to import prices: improvement, though exports become harder to sell |
| The domestic currency depreciates | Import prices in local currency rise: usually a deterioration |
| New producers or new technology raise world supply of the country's export | Export prices fall: deterioration |
| Substitutes replace a product (for example synthetic materials for natural fibres) | Export prices fall: deterioration |
Not necessarily. If export prices rise because the country's goods have become dearer than its rivals', buyers whose demand is price-elastic may switch away, and export earnings can fall. An improvement caused by stronger world demand is good news; one caused by rising costs may not be. The same care applies to a deterioration: if it comes from higher productivity that lowers export prices, the country may sell much more.
The long run for primary producers. In 1950 the economists Raúl Prebisch and Hans Singer argued that the prices of primary products tend to fall over the long run relative to the prices of manufactured goods, so countries that export mainly raw materials face a long-term deterioration in their terms of trade. The idea is still debated, but it is one reason countries like Rwanda try to add value to their exports and to widen the range of goods they sell.
Warning
Terms of trade are not the balance of trade. The terms of trade compare prices (an index number with no currency unit); the balance of trade compares values (exports minus imports, in money). A country can have improving terms of trade and a worsening trade deficit at the same time.
Definition
Free trade: international trade with no government restrictions such as tariffs, quotas or subsidies, so that goods move between countries as freely as within them.
World Trade Organization (WTO): the international organisation that sets and enforces the rules of trade between its members and hosts negotiations to reduce barriers. It began on 1 January 1995, taking over from the General Agreement on Tariffs and Trade (GATT) of 1947. Rwanda has been a member of the WTO since 22 May 1996 and was a member of GATT from 1 January 1966.
| For free trade | Against unrestricted free trade |
|---|---|
| Countries specialise by comparative advantage, so world output rises | New (infant) industries cannot survive against established foreign firms |
| Consumers get lower prices and wider choice | Imports can cause unemployment in firms that compete with them |
| Larger markets bring economies of scale | Countries may become dependent on a few exports and on imported food and fuel |
| Competition pushes local firms to be efficient | Foreign firms may dump goods below cost to capture the market |
| Ideas and technology spread faster | Governments of poor countries lose tariff revenue |
| Countries that trade have reasons to stay at peace | Strategic goods (food, medicine, energy) may need local production for security |
Tip
"X over M." The terms of trade put eXport prices on top and iMport prices below. If the top grows faster, the index rises and the terms have improved.
Important
Discuss. Rwanda's terms of trade index rose by about 13% between 2023 and 2024. Does that mean Rwandans were better off? What else would you need to know? (Think about export volumes, what drove the price changes, and who receives the export earnings.)
tutor2u, "Terms of Trade I A Level and IB Economics" (about 8 minutes, 2019). A revision talk that separates the terms of trade from the balance of trade and explains what makes them improve or worsen. Note his warning about an 'improvement' that is not good news.
Practice
Sources and credits
Written by Ganzaa: the graph, the number line, the tables, the worked examples and the practice items. The coffee and fuel prices and the index numbers in the examples are illustrative. This lesson adapts CC BY-SA material and is shared under CC BY-SA 4.0.
