The terms of trade index and what moves it; the consumption line on a PPF rotating with the terms of trade; effects on real income, the trade balance and developing countries; the changing pattern of UK trade. Through the 2026 oil shock.
Brent crude, the benchmark for two thirds of the world’s oil, averaged about $69 a barrel in 2025 and was expected to fall further. Then conflict between the United States and Iran from early 2026 cut traffic through the Strait of Hormuz, through which a fifth of the world’s oil passes. Brent passed $100 on 9 September 2026 for the first time since July, and closed at $116.72 on 23 October after attacks on tankers and Saudi airports; tanker rates from the Gulf to China rose from a few dollars a barrel to $30–40. Forecasters put the 2026 average near $100, more than 40% above 2025.
For the UK, Japan, India and other importers, every barrel costs more in exports: a deterioration in the terms of trade and a transfer of income to producers. For Saudi Arabia, Norway and Nigeria it is the reverse. The Bank of England cited the shock when it raised Bank Rate to 4% on 5 November.
What are the terms of trade, how are they measured, and why do they matter so much to some countries and so little to others?
Source: Reuters and Oman Observer price reports, September–October 2026; Oxford Institute for Energy Studies, Oil Monthly, October 2026; BMI (Fitch Solutions), 2025 average.
The terms of trade measure the price of a country’s exports relative to the price of its imports: index = (export price index ÷ import price index) × 100. An improvement means export prices have risen relative to import prices, so a given volume of exports buys more imports; a deterioration means the opposite. On a PPF diagram the terms of trade set the slope of the line along which a country can trade from its specialisation point; an improvement rotates the line outward and lets the country consume more.
Causes of change. Commodity prices (oil, metals, food), which dominate the terms of trade of countries that export or import them; the exchange rate, since an appreciation raises export prices in foreign currency and lowers import prices in domestic currency; relative inflation; changes in productivity that lower a country’s export prices; and shifts in world demand, such as China’s appetite for raw materials in the 2000s.
Effects. An improvement raises real income: the same work buys more from abroad. But its effect on the trade balance depends on elasticities: if export prices rise and demand is elastic, export volumes fall more than price rises, and the balance worsens. For developing countries dependent on primary exports, the Prebisch–Singer hypothesis predicts a long-run deterioration that transfers the gains from productivity growth to richer importers; booms and busts in their terms of trade make budgets and currencies unstable. The pattern of trade, who trades what with whom, shifts with comparative advantage, emerging economies, trading blocs and exchange rates: the UK’s trade has moved from goods to services, from the EU towards the rest of the world since 2016, and towards Asia.
Brent crude averaged $69 a barrel in 2025. By late October 2026 it was $116.
Nothing changed in what Britain sells abroad: the same cars, whisky, financial services and pharmaceuticals, at much the same prices. But every barrel it imports now costs two thirds more.
What has happened to the UK’s terms of trade?
The terms of trade are the ratio of export prices to import prices. Dearer oil raises import prices for an importer like the UK, so the ratio falls: a deterioration. For Saudi Arabia or Norway the same shock is an improvement. The lesson shows what that does to living standards, trade balances and development.
On the diagram. At home 1 machine costs 2 shirts along the PPF (40 machines or 80 shirts). The country specialises at A, 40 machines, and trades at the world rate of 3 shirts per machine: the consumption line runs from A to 120 shirts. It keeps 20 machines, exports 20, and consumes 60 shirts at C1, beyond its frontier. The slope of that line is the terms of trade.
Check: A country’s export price index rises from 100 to 110 and its import price index from 100 to 125. Its terms of trade index is now:
(110 ÷ 125) × 100 = 88. Export prices rose, but import prices rose by more, so each unit of exports buys fewer imports.
An improvement. If a machine now fetches 4 shirts, the line swings out to 160 and the same 20 machines buy 80 shirts at C2. Nothing was produced that was not produced before; the country is richer because the world pays more for what it makes. Australia in the 2000s iron ore boom, and Gulf producers in 2026, are living on this diagram.
Check: World demand for machines rises and the terms of trade improve to 4 shirts per machine. Exporting the same 20 machines, the country can now consume:
20 machines × 4 = 80 shirts. The consumption line rotates outward around A; the gain is pure purchasing power.
A deterioration. Dearer imports swing the line inward: at 2 shirts per machine it lies on the PPF itself, and C3 is where the country could have been without trading. Real income has fallen by a third of its shirt consumption with no change in output. This is the 2026 shock for oil importers: the same exports, fewer imports, and the difference transferred to producers abroad.
Teacher tip: Ask students why the UK felt the 2022 and 2026 energy shocks as a fall in living standards even though GDP barely moved: the terms of trade are the answer. GDP measures what is produced; the terms of trade decide what it buys.
Check: An oil shock raises the country’s import prices so that a machine now buys only 2 shirts. The consumption line:
At 2 shirts per machine the world rate equals the home opportunity cost; the country is no better off trading than not. Any worse and it would stop exporting machines.
The trade balance is a separate question. Higher export prices raise revenue only if volumes hold up: inelastic demand for oil means Gulf surpluses balloon; elastic demand for a manufacturer’s cars means an improvement can cut the balance. An improvement also makes imports cheap, which can hollow out domestic producers: the Dutch disease of resource booms.
Check: A commodity exporter’s terms of trade improve by 30% because of a price boom. Its trade balance:
The effect depends on elasticities. Price-inelastic exports earn more as prices rise; price-elastic exports lose volume faster than price gains.
The pattern of trade is who sells what to whom, and it moves with comparative advantage, emerging economies (China from 2001), trading blocs (the single market, then Brexit) and exchange rates. The UK now exports services as much as goods, and trades less with the EU than in 2015 and more with the US and Asia. For developing countries, diversifying out of primary exports is the way off the rollercoaster.
Check: The UK’s pattern of trade has shifted since 2000 mainly towards:
Services are now about half of UK exports; the EU share has fallen since 2016 while the US is the largest single partner.
C2 is marked at 50 shirts, inside the original line. An improvement rotates the line outward: 20 machines at 4 shirts each buy 80 shirts, so C2 lies on the new line at 80, not at 50.
Evaluate the likely effects of a sharp rise in the world price of oil on the terms of trade and economies of oil-importing and oil-exporting countries.
The terms of trade are the ratio of a country’s export prices to its import prices, measured as an index. A rise in the world oil price raises import prices for importers and export prices for exporters, so it worsens the terms of trade of the first and improves those of the second. On a PPF diagram the consumption line from a country’s specialisation point rotates inward for the importer and outward for the exporter: the same production buys fewer or more imports.
For an oil importer such as the UK, Japan or India, the 2026 shock, which took Brent from an average of $69 in 2025 to above $100 from September and $116 by late October, is a fall in real income: more exports must be sent abroad to buy the same energy, and the difference is transferred to producers. It also raises costs and prices, pushing inflation up, which is why the Bank of England raised Bank Rate to 4% in November 2026 even as growth slowed; and it tends to worsen the trade balance, since demand for oil is price-inelastic in the short run, so the import bill rises almost in proportion to price. For an exporter such as Saudi Arabia, Norway or Nigeria, the same inelasticity means export revenue, the current account surplus and government revenue all rise sharply, and the improvement in the terms of trade raises real income without any extra production.
**However,** the effects depend on several things. The size of oil in a country’s trade matters: the UK, which produces some oil and whose exports are mostly services, is far less exposed than India or a small island state. The exchange rate adjusts: a depreciation in importing countries partly offsets the shock while an appreciation in exporters erodes their other industries, the Dutch disease. Duration matters: a spike that passes within a year, as in 2022, is absorbed; a sustained rise changes investment and the energy mix. And for exporters an improvement in the terms of trade can be squandered or spent pro-cyclically; the countries that fared best after past booms were those, such as Norway and Chile, that saved the windfall in stabilisation funds. Elastic demand in the long run, as consumers switch to electric vehicles and renewables, means the exporter’s gain fades.
On balance a sharp oil price rise redistributes real income from importers to exporters through the terms of trade, with the importers’ loss showing up as higher inflation and weaker trade balances and the exporters’ gain as surpluses. The size of the effect is set by exposure, the exchange rate and duration, and the long-run winners are the exporters that save the gain and the importers that use the shock to reduce their dependence.
Oil prices: Brent crude averaged about $69 a barrel in 2025 (BMI); it passed $100 on 9 September 2026 for the first time since July and closed at $116.72 on 23 October 2026 (Reuters, Oman Observer); the Oxford Institute for Energy Studies put the likely 2026 average at $95–105 (Oil Monthly, October 2026). The production possibility frontier on the diagram is invented. Diagrams drawn with Rough.js and perfect-freehand, both MIT licensed.