Changes in the terms of trade are caused by changes in the demand for and supply of imports and exports, and by changes in the exchange rate.

Favourable movement

Essentially what causes a favourable movement in the terms of trade is a rise in export prices relative to import prices.

Increase in the demand for exports

An increase in the demand for exports would increase their price and so cause a favourable movement in the terms of trade.

A rise in relative inflation rate

A rise in a country’s relative inflation rate would also make its export prices higher relative to its import prices.

Unfavourable movement

An unfavourable movement occurs when there is a fall in export prices relative to import prices.

Devaluation

A devaluation is sometimes referred to as a deliberate deterioration of its terms of trade. This is because it is a deliberate attempt to reduce export prices and raise import prices in order to make the country’s products more internationally competitive.