Terms of trade are influenced by a number of factors. Important among them are given below:
1. Elasticity of Demand:
The elasticity of demand for exports and imports of a country influence its terms of trade. If the demand for a country’s exports is less elastic as compared to her imports, the terms of trade will tend to be favourable because the exports can command higher price than imports.
On the other hand, if the demand for imports is less elastic than that for exports, the terms of trade will be unfavourable.
2. Elasticity of Supply:
The nature of elasticity of supply also significantly influence the country’s terms of trade. If the supply of a country’s exports is more elastic than the imports, the terms of trade will tend to be favourable.
3. Nature of Goods:
If a country is producing and exporting only primary goods, and importing manufactured goods, the terms of trade will be unfavourable.
4. Economic Development:
The economic development has two types of effects: (a) The demand effect: It refers to the increase in demand for imports as a result of increase in income associated with economic development, (b) The supply effect: It refers to the increase in supply of import substitutes or import competing goods. The net effect of economic development depends upon the extent of these two effects.
5. Rate of Exchange:
Changes in the rate of exchange of a country’s currency also affect its terms of trade. If a country’s currency appreciates, its terms of trade will improve because a rise in the value of the currency causes an increase in the export prices and decrease in the import prices.
6. Tariff Policy:
Tariffs and quotas also influence the terms of trade. These measures, if not retaliated by other countries, improve a country’s terms of trade by restricting imports.
7. Size of Population:
An overpopulated country will have larger demand for imports. As a result, the terms of trade will tend to be unfavourable in this case relative to the under populated or optimally populated country.
8. Size of Country:
A larger country will tend to have less favourable terms of trade as compared to a smaller country. This is because the smaller country can reap the gains of economies of scale enjoyed by the larger one in the international trade.
9. Degree of Competition:
If a country enjoys monopoly power in case of its exports and there are many alternative sources of supply of its imports, then it will have favourable terms of trade.