• Definition of terms of trade
Terms of trade is the quantity of foreign goods and services (imports) that a country can purchase from the proceeds of the sale of its goods and services (exports) of a given quantity from another country. It is a measure of a country's trading clout and is expressed as the ratio of an index of export prices to an index of import prices. Terms of trade of a country improve when the prices of its exports rise in comparison with the prices of its imports, vice versa. In international economics and international trade, terms of trades or TOT is (Imports)/(Exports), or (Price Exports)/(Price Imports). In layman's terms it means how much is imported per export. "Terms of trade" are sometimes used as a proxy for the relative social welfare of a country, but this heuristic is technically questionable and should be used with extreme caution. An improvement in a nation's terms of trade (the increase of the ratio) is good for that country in the sense that it has to pay less for the products it imports. That is, it has to give up fewer exports for the imports it receives.
An improvement in the terms of trade means that the export prices have risen relative to import prices.
A decrease in improvement in the terms of trade means that the export prices have fallen relative to import prices.
Consequences of a change in the terms of trade[]
If this ratio changes, say when a country [A] exports 100 dollars worth of product and then imports 50 dollars worth of product they have a ratio of 2:1. From the standpoint of the other country [B], this is a consequence because they are exchanging 50 dollars of exports for 100 dollars of imports. They are worse off because they are importing twice the amount they are exporting. They recieve half of what they originally gave away. This makes them have a loss in the trade, hence a consequence that effects their entire economy and can worsen their economy if the trade continues. In this scenario, the country [A] with the 2:1 ratio of export prices to import prices would have their current account in surplus. This is also indicative of the domestic currency being favored in exchange rate markets. However, if the terms of the trade agreement change, and country [B] starts gaining more out of the trade than country [A], that would be a positive consequence of the trade for country [B], but a negative one for country [A].
The significance of deteriorating terms of trade for developing countries[]
If the terms of trade deteriorate, the country will effectively be getting a smaller ratio of money from exports to money they are paying for imports of a product. This means the country will not be as well off as before because it is not getting as good of a deal in terms of an export/import ratio as before. When the ratio falls, a country is said to have deteriorating terms of trade. It hinders development and lowers Aggregate Demand.