production at point S, Canada can now afford to consume at a point like
where consumption of both wheat and cloth has increased.
A rise in a country’s terms of trade is beneficial because it expands the country’s consumption
possibilities.Conversely, a reduction in the price of a country’s exports (relative to the
price of its imports) is harmful for a country. In Figure 32-7 , this is
shown as a change of the terms of trade from to Even though
production may remain unchanged, the range of goods available to be
consumed falls, and this reduction in consumption possibilities leads to
an overall loss of welfare.
How do we measure the terms of trade in real economies? Because
international trade involves many countries and many products, we
cannot use the simple ratio of the prices of two goods as in Figure 32-7
The basic principle, however, is the same. A country’s terms of trade are
computed as an index number:
A rise in the index is referred to as a terms of trade improvement. A
decrease in the index is called a terms of trade deterioration. For example,
oil-exporting countries experienced significant terms-of-trade
improvements when the world price of oil increased sharply in the mid-
1990s and again in the mid-2000s. When world oil prices fell sharply in
2014–2015, the same countries experienced a large deterioration in their
T 1 T 0.Terms of trade=Index of import pricesIndex of export prices× 100