4 Provincial terms of trade support real income growth

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Despite the increase in energy prices, the terms of trade improved in both Quebec and Ontario between 2002 and 2007 (Figure 4). The terms of trade is the ratio of export prices to import prices, and represents the rate at which exports are traded for imports. An improvement in the terms of trade allows an economy to spend more than its domestic production alone would suggest, by increasing purchasing power on world markets.

Figure 4
Terms of trade vs. commodity prices

The effect of terms-of-trade changes on real income can be measured using real gross domestic income (GDI). Real GDI is GDP deflated by the price of domestic spending. Rather than focusing only on production, it accounts for changes in purchasing power. It is therefore an income concept that reflects the goods and services an economy can use for consumption and investment instead of the goods and services an economy produces.

At the national level, the rising terms of trade were an important source of real income growth between 2002 and 2007. Canadian real GDI growth averaged 3.9%, 1.1 percentage points more than real GDP, as the terms-of-trade improvement allowed consumption (3.8%) and investment (6.7%) to increase faster than real output. In Ontario, consumption rose an average of 3.4% as real GDI (2.4%) growth outpaced real GDP (2.2%). In Quebec, consumption growth averaged 3.3% as real GDI (2.6%) rose faster than real GDP (2.0%).

Although the terms of trade increased after 2002 in both Quebec and Ontario, the sources of the improvements were noticeably different. For Quebec, the effect of Asia integrating into world markets contributed to higher export prices (notably metals) and lower import prices, despite the rise in energy prices (Figure 5). The combination of lower manufactured prices and the appreciation of the dollar translated into a sufficiently large drop in non-energy import prices to overcome the rising price of energy imports. The net result of lower import prices and rising export prices increased Quebec's terms oftrade by an average of 1.1% per year.

Figure 5
Average price changes, 2002 to 2007

Ontario's terms of trade also improved, but the gain came from import prices declining faster than the drop in export prices. The pattern of price movements suggests that as Asia integrated into world markets and the dollar appreciated, downward pressure on the price of manufactured goods led manufacturers in Ontario to lower their prices. But, overall export prices did not decline as quickly as import prices, and the terms of trade rose. Still, the increase in Ontario's terms of trade was only half that of Quebec, and markedly less than for all of Canada.