U.S. Terms of Trade: Significance, Trends, and Policy

Publication Date: September 2004

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Trade

Type:

Abstract:

The nation's terms of trade -- the ratio of an index of export prices to an index of import prices -- is a measure of the export cost of acquiring desired imports. Increases and decreases in its terms of trade indicate whether a nation's gains from trade are rising or falling. A sustained trend of improvement of the terms of trade expands what our income will buy on the world market and can make a significant contribution to the long-term growth of economic welfare. Similarly, a falling terms of trade raises the export cost of acquiring imports and reduces real income and the domestic living standard. While trade is a process of mutual beneficial exchange, each trading partner's share of those benefits can change over time, and movement of the terms of trade is an indicator of that changing share.

A force or forces that changes the average level of export or import prices will change a nation's terms of trade. In this regard we can first distinguish between transitory and more enduring forces. Relatively short-term changes in national spending patterns can lead to similarly short-term changes in the terms of trade. These spending changes could be the result of changes in economic policy or swings in private sector spending over the course of the business cycle. In either case, the general scenario will be that the spending change induces either an inflow or outflow of foreign capital and an associated appreciation or depreciation of the exchange rate. A more enduring effect on the terms of trade is likely to emerge from more fundamental changes in world demand and the productive prowess of the economy. In general, anything that leads to an increased demand for the nation's exports would cause that nation's terms of trade to improve. Such demand changes will often be at the caprice of shifting tastes and preferences in the market place, for good and for bad. It is also possible that an economy can do things that raise the probability that its exports will be highly desirable.

A steady post-war rise in the U.S. terms of trade appears to have ended in the late 1960s. The rate of decline of the U.S. terms of trade was fairly substantial through the 1970s. In the 1980s, the pattern changed again with the terms of trade strengthening through mid-decade, then resuming its deterioration. In the 1990s, the deterioration stopped, with the terms of trade remaining relatively steady through mid-decade, then strengthening moderately through the end of the decade. By the year 2003, the U.S. terms of trade was more or less at the same level that it was in the 1980s, suggesting that the post -- 1960s trend deterioration seems to have stopped, with the U.S. terms of trade at a lower but generally stable level.

The terms of trade is unlikely to be a direct focus of economic policy, with changes most often a collateral effect of policies aimed at other economic goals. Nevertheless, it is useful to understand how various economic policies would influence the terms of trade, so as to craft policies that have the greatest positive effect on economic well-being. Also, it is possible to configure policies that, while primarily focused on other goals, maximize the probability of a favorable terms of trade effect. As such, particular configurations of macroeconomic policy, trade policy, and technology policy each have the potential for improving the nation's terms of trade. This report will not be updated.