In macroeconomic terms, what does a 'terms of trade' shock refer to?

• A. Changes in export prices relative to import prices that affect real income
• B. Changes in labor force participation
• C. Changes in government budget balance
• D. Changes in monetary policy regime

Answer: (A)

A terms of trade shock is a sudden change in the relative price of a country’s exports compared with its imports. This ratio, export prices divided by import prices, determines how much imports a country can buy with its export revenue. When export prices rise relative to import prices, the terms of trade improve, meaning real income from trade goes up because you can fund more or better imports with the same export earnings. When export prices fall relative to import prices, the terms of trade worsen, and real income falls for the same reason.

That is exactly what the choice describes: changes in export prices relative to import prices that affect real income. The other possibilities describe domestic labor, fiscal balance, or monetary policy—factors unrelated to the relative prices of traded goods that define the terms of trade.