Executive Summary

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Economists often assume that real gross domestic product (GDP) — a measure of the earnings generated from production — represents the volume of goods and services that can be purchased with those earnings. This assumption is valid for countries where a small percentage of GDP is derived from trade. However, for a small open economy, such as Canada, where trade activity represents a significant portion of nominal GDP, changes in the relative price of traded and non-traded goods, or in the relative price of exports and imports, can have important consequences.

In particular, the terms of trade (the ratio of export to import prices) and the real exchange rate (the ratio of traded to non-traded goods prices) can affect the volume of goods and services that can be purchased with real GDP. Terms of trade shifts change the number of imports that can be purchased with a given level of exports. Improvements in an economy's terms of trade are therefore analogous to productivity growth: economic agents are able to consume more goods and services from their available resource base. Real exchange rate changes capture increases (decreases) in nominal income that arise from agents earning more (less) from net exports.

The combination of the two effects is the trading gain a country realizes when the price ratios change. By adjusting real GDP for trading gains it is possible to create a measure of the real purchasing power of income referred to as real gross domestic income (GDI). This paper examines the evolution of real GDP and real gross domestic income (GDI) from 1981 to 2005 in Canada and in the provinces. In doing so, it examines a number of questions pertinent to understanding the evolution of the domestic economy:

1. Is there a preferable method for calculating real GDI?

   The difference between real GDP and real GDI comes from how exports and imports are treated. Real GDP deflates exports and imports separately, while real GDI deflates net exports. Consequently it is necessary to choose a net export deflator. While there is no consensus about which choice of deflator is optimal, in this paper the final domestic demand (FDD) deflator  is employed. The FDD deflator makes it possible to disaggregate trading gains into real exchange rate and terms of trade effects. Other deflator choices (including export or import prices or their geometric mean) lead to solutions that are constrained versions of this adjustment.

2. Which effect is more important: the terms of trade or the real exchange rate?

   For most provinces the terms of trade effect is more important. The result arises because the magnitude of the terms of trade effect is proportional to the average share of imports and exports in nominal GDP, while the real exchange rate effect is proportional to the share of net exports. In most provinces, the share of net exports is small while the average of the export and import shares is large. The terms of trade, therefore, are more important for understanding the evolution of provincial real GDI. However, in Nova Scotia and New Brunswick there are trade deficits that lead to a larger magnitude real exchange rate effect. As a result, the real exchange rate and terms of trade effects both lead to noticeable changes in their respective real GDIs.

   In Canada the share of exports and imports is large, relative to net exports. Consequently, terms of trade fluctuations have a larger impact on Canadian real GDI than real exchange rate movements.

3. What are the sources of trading gains?

   Trading gains are primarily driven by commodity price changes, fluctuations in the Canada–U.S. dollar exchange rate and imported machinery and equipment prices. As a result, foreign productivity growth, current account corrections and fiscal and monetary policies can also be important determinants of trading gains.

4. When are trading gains the most influential?

   Trading gains are predominantly a short-run phenomenon. They capture changes in the purchasing power of real GDP that arise from relative price shifts, which manifest themselves quickly in the domestic economy as changes in imports, consumption and investment. Importantly, trading gains can lead to real GDI, consumption and import growth without an accompanying change in real GDP.

5. How have trading gains affected the economy recently?

   Increases in commodity prices, and the appreciation of the Canadian–U.S. dollar exchange rate, have led to significant increases in trading gains for many provinces, as well as for Canada. A number of provinces have experienced trading gains from 2002 to 2005 — notably British Columbia, Alberta, Saskatchewan, Nova Scotia and Newfoundland and Labrador. Moreover, while trading gains have held back real GDI in Ontario, there has not been a similar effect in Quebec.

   From 2003 to 2005, rising energy and commodity prices led to positive trading gains in a wide range of provinces. This differs from the early 1980s, when trading gains in energy exporting regions were offset by losses in energy importing regions. The purchasing power growth of the Canadian economy, rather than being dampened by offsetting regional effects, has expanded since 2002. Consumers and business across the country have benefited from the trading gains that have contributed to consumption, investment and import growth.

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