Definition
Terms of trade is a ratio showing how much foreign merchandise a country can import with the money it earns from exporting one item. Put simply, it is the price exchange rate between a country's exports and its imports, and it is a leading report card for the real buying power of a national economy.
How many barrels of oil can one smartphone get you?
Say you are swapping snacks with a friend, and one bag of your chips gets you 5 of their candies. Great deal. But then candy prices go up, and now a bag of chips gets you only 1 candy. You made the same chips, yet you feel like you lost out.
Trade between countries works the same way. When you calculate the ratio between the prices of the main goods a country exports and the prices of the goods it buys from abroad, you get the net barter terms of trade. It is usually calculated by dividing the export price index by the import price index and multiplying by 100.
If the index rises from before, terms of trade have improved. If it falls, they have turned unfavorable. A value of 100 means the level of the base year. So if selling one car lets you buy more crude oil than before, we say the terms of trade have improved.
Why is life still tight when we sold so much?
Imagine running the factories day and night and exporting twice as many cars as last year. At first glance, exports doubled, so the country should be twice as well off. In reality, that is not always true.
What if, in the meantime, global oil prices tripled? Car prices stay put, but the oil you have to import gets so expensive that you must sell far more cars than before just to fill up the same amount of oil.
When the prices of the raw materials a country buys rise faster than the prices of the goods it sells, we say the terms of trade have worsened. Even if export volume grows, if the terms of trade get worse by a bigger margin, the gain people actually keep shrinks, and household budgets can feel the squeeze.
To be more precise: price and volume together
To understand terms of trade in depth, you need to look at total export volume as well as the price ratio per item. The measure used for that is the income terms of trade.
Even if the net barter terms of trade, the per-item price ratio, get a bit worse, a huge jump in export quantity can actually raise a country's total buying power for foreign goods. The income terms of trade multiply the net barter terms of trade by the export quantity index to show this overall capacity.
To be more precise, terms of trade are a different idea from the trade balance, which shows a trade surplus or deficit. If the trade balance is simply the 'total money left in the account,' terms of trade are an important compass that shows the relative price of exports and imports, in other words the quality of the buying power trade gives you. Terms of trade can improve because export prices rise, even while price competitiveness actually falls, so the two are not the same thing.
Common misconceptions
If you export a lot and run a trade surplus, your terms of trade are sure to improve.
The trade balance and the terms of trade are different measures. Even if you ran a surplus by selling huge volumes at bargain prices, the terms of trade, the exchange ratio per item, may have actually gotten worse.
Where you meet it
When semiconductor export prices rise and global oil prices fall, a country's terms of trade improve a lot.
When the price of exported cars stays the same but the price of imported raw materials spikes, the terms of trade worsen.
In one sentence
Terms of trade show how much you can import by selling one unit of exports, and they measure a country's real buying power.