Business Economics · Importance of international trade

Terms of Trade and Trade Balance Explained

Updated 11 October 2026 · Fact-checked

Terms of trade (ToT) measure how many imports a country can buy per unit of exports. The index is (export price index ÷ import price index) × 100. The balance of trade is exports minus imports of goods. The balance of payments is a wider record of all international transactions.

Understand Terms of Trade and Trade Balance

Terms of trade tell you the price of a country's exports relative to the price of its imports. If export prices rise faster than import prices, each unit of exports buys more imports. The country's terms of trade have improved. If import prices rise faster, they have worsened.

You measure this with price indices, not quantities. Take the export price index and the import price index, both on the same base year. Divide one by the other and multiply by 100. A value above 100 means an improvement compared with the base year. A value below 100 means a deterioration. This is the net barter terms of trade.

Many things move the terms of trade. A change in the exchange rate, a shift in world demand for your exports, a commodity price shock such as an oil price rise for an oil importer, and productivity changes all matter. An improvement is usually good for living standards, but it does not by itself show the trade balance has improved. That depends on volumes as well as prices.

The balance of trade is the value of visible exports (goods) minus the value of visible imports. A positive result is a surplus. A negative result is a deficit. Some books include services and call this the balance of trade in goods and services, so read the question carefully.

The balance of payments (BoP) records all transactions between residents and non-residents over a period. It has a current account (trade in goods, trade in services, primary income such as profits and interest, and secondary income such as remittances and transfers), a capital account (small capital transfers and non-produced assets) and a financial account (direct investment, portfolio investment, other investment and reserve assets). In principle the whole BoP sums to zero, because every transaction has two sides. Any gap appears as net errors and omissions.

Key rules to remember

Net barter terms of trade: ToT index = (Export price index ÷ Import price index) × 100; Both indices must share the same base year. Above 100 is an improvement, below 100 a deterioration.
Balance of trade: Balance of trade = Value of exports − Value of imports; Use goods only unless the question says goods and services. Positive is surplus, negative is deficit.
Change in terms of trade: New ToT = Old ToT × (1 + export price change) ÷ (1 + import price change); Use decimals for the changes, for example 10% = 0.10.
Current account: Current account = Trade in goods + Trade in services + Primary income + Secondary income; Each item is net: receipts minus payments.
Balance of payments identity: Current account + Capital account + Financial account + Net errors and omissions = 0; This follows the usual sign convention where a financial account inflow of funds is shown as net borrowing. Check the sign convention the question uses.

How to solve Terms of Trade and Trade Balance questions

Use this method for any question on terms of trade or balance of payments.

1Decide what is asked: a terms of trade index, a change in it, a trade balance, or a BoP component.
2List the data given and check the base year, units and time period.
3For terms of trade, divide the export price index by the import price index and multiply by 100.
4For a percentage price change, convert it to a factor such as 1.10 or 0.95 before dividing.
5For balances, subtract imports from exports, or add net items within the current account. Keep the sign.
6Interpret the result in words: improved or worsened, surplus or deficit.
7Where asked, explain causes or effects, such as exchange rate moves, demand shifts or capital flows.
8Check that your answer is in the right units and that you have not mixed goods with services.

Quickest way: Factor shortcut for ToT changes

When to use it: Use it when a question gives percentage changes in export and import prices and asks for the new index or whether terms of trade improved.

Write the export factor, for example 1.08.
Write the import factor, for example 1.12.
Divide export factor by import factor: 1.08 ÷ 1.12 = 0.964.
Multiply by the old index. Below 1 means deterioration, above 1 means improvement.
Do not subtract the percentages as a final answer.

Common mistakes in Terms of Trade and Trade Balance

Inverting the ratio, using import prices over export prices.
Students recall that the index compares two price indices but forget which goes on top.
Fix: Remember: exports on top. Higher export prices relative to import prices means an improvement.
Saying that improved terms of trade always improve the trade balance.
Price effects are confused with the value of trade, which also depends on volumes.
Fix: State that the effect depends on how quantities respond. Higher export prices may reduce export volumes.
Using the balance of trade and the balance of payments as the same thing.
Both are described as a balance with the rest of the world.
Fix: Balance of trade covers goods only. The BoP covers all transactions, including services, income, transfers and capital flows.
Subtracting percentage changes to find the new terms of trade.
It seems natural to say 8% minus 12% equals −4%.
Fix: Divide the factors: 1.08 ÷ 1.12 gives a fall of about 3.6%.
Placing remittances or investment income in the trade balance.
They are receipts from abroad, so they look like exports.
Fix: They belong in the current account as secondary and primary income, not in the trade balance.
Forgetting that the BoP sums to zero in principle.
A current account deficit looks like a lasting imbalance.
Fix: A current account deficit is matched by net inflows on the capital and financial accounts, or by changes in reserves, apart from errors and omissions.

Worked examples

Example 1

In the base year, a country's export price index and import price index are both 100. After a period the export price index is 126 and the import price index is 140. Calculate the terms of trade index and state what has happened.

Show the solution

Use ToT = (export price index ÷ import price index) × 100.
ToT = (126 ÷ 140) × 100.
126 ÷ 140 = 0.9.
ToT = 90.

Answer: The terms of trade index is 90. It is below 100, so the terms of trade have deteriorated by 10% compared with the base year. Each unit of exports now buys fewer imports.

Example 2

A country exports goods worth ₹8,40,000 crore and imports goods worth ₹12,60,000 crore. It earns ₹6,00,000 crore from services exports and pays ₹3,60,000 crore for services imports. Net primary and secondary income is +₹1,20,000 crore. Find the balance of trade and the current account balance.

Show the solution

Balance of trade = 8,40,000 − 12,60,000 = −4,20,000 crore.
Net services = 6,00,000 − 3,60,000 = +2,40,000 crore.
Current account = goods balance + services balance + net income.
Current account = −4,20,000 + 2,40,000 + 1,20,000 = −60,000 crore.
A current account deficit must be financed by net inflows through the capital and financial accounts or by drawing on reserves.

Answer: The balance of trade is a deficit of ₹4,20,000 crore. The current account balance is a deficit of ₹60,000 crore.

Exam tips

Show the formula first, then the substitution, then the interpretation. Marks are given for each.
In MCQs, check which way the ratio is built and whether the data is goods only or goods and services.
For written questions on BoP, name the three accounts and give an example item for each.
When asked about causes of a change in terms of trade, give both price-side and exchange rate-side reasons.
Always state the sign convention you are using for the financial account.

Practice questions from Importance of international trade

Terms of Trade and Trade Balance in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Terms of Trade and Trade Balance: frequently asked questions

What is the difference between balance of trade and balance of payments?

The balance of trade is exports minus imports of goods only. The balance of payments records all transactions with the rest of the world, including services, income, transfers and capital flows. The trade balance is one part of the current account within it.

How do you calculate the terms of trade index?

Divide the export price index by the import price index and multiply by 100. Both indices must use the same base year. A result above 100 means an improvement since the base year.

What does a fall in terms of trade mean?

It means export prices have fallen relative to import prices. The country must give up more exports to buy the same imports. Real income from trade tends to fall, though the trade balance effect depends on volumes.

Does the balance of payments always balance?

In accounting terms, yes, apart from net errors and omissions, because each transaction is recorded twice. Individual accounts, such as the current account, can be in deficit or surplus. The other accounts and reserves offset them.