What price will our exports fetch abroad? What will we have to pay for imports? The answer to these questions is given by the terms of trade.
The terms of trade is simply the ratio of export prices to import prices.
Canada exports a lot of oil, so when the price of oil goes up, its terms of trade improve. It earns more foreign currency on its exports. Meanwhile, foreign investors rush to buy shares in Canadian oil companies. Both those things create extra demand for Canadian dollars.
The ratio is calculated from the average prices of many goods and services that are traded internationally. The prices are weighted by the relative importance of each product traded.
Improvement in the terms of trade
If the index increases, this is described as a favourable movement or an improvement in the terms of trade. Fewer exports now have to be sold to purchase any given quantity of imports.
Deterioration in the terms of trade
An unfavourable movement or deterioration in the terms of trade means that the index number has fallen. Now more exports will have to be exchanged to gain the same quantity of imports.