Terms of trade

Imagine a country that exports coffee and imports oil. If oil prices double but coffee prices stay flat, the country must now export twice as much coffee to pay for the same amount of oil. Its terms of trade have deteriorated: each unit of exports buys fewer imports. The calculation is straightforward — divide the export price index by the import price index — but the implications for living standards and inflation can be profound.

For energy-importing economies like the UK, Japan, or most of central Europe, a surge in global energy prices is a terms-of-trade shock: import costs rise, which directly pushes up consumer energy bills and — through higher transport and production costs — eventually everything else. The World Bank Commodity Markets Outlook tracks the commodity prices that drive terms-of-trade movements for most countries.

Terms of trade = (Export Price Index / Import Price Index) × 100. A value above 100 means exports are relatively more valuable than a chosen base period; a falling index means deterioration. National statistics agencies and central banks publish export and import price deflators as part of their trade statistics. The OECD and World Bank WDI both publish harmonised long-run series for cross-country comparison.

Terms-of-trade shocks are one of the main ways global price changes transmit to domestic inflation. When import prices rise faster than export prices, the domestic economy faces a real income loss: it can afford less from the rest of the world. This cost often gets distributed as higher consumer prices (if firms pass through import costs), lower real wages (if workers absorb the cost), or reduced profits. The distributional question — who bears the terms-of-trade loss — is one of the central political economy questions during commodity price shocks. The IMF WEO and ECB Economic Bulletin analyse terms-of-trade effects on inflation in their regular assessments.

A terms-of-trade deterioration is not always inflationary in CPI terms. If the deterioration is absorbed by lower corporate profit margins, workers' real wages fall but consumer prices might not rise proportionately. Whether the terms-of-trade loss gets passed to consumers or absorbed by firms is an empirical question that differs by sector, country, and degree of market competition. The ECB's research on profits and inflation decomposed how much of the 2021–2022 inflation was profit-driven versus cost-driven — an important distinction when assessing the distributional effects of commodity price shocks.