1 Introduction

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Bode and Rey (2006) note that closed economy models in the spirit of Sala-i-Martin (1990) and Mankiw, Romer and Weil (1992) have been the basis for much of the work examining regional income convergence. Studies following this tradition often use real gross domestic product (GDP) as an aggregate income measure. However, real GDP does not adequately represent real income growth when certain types of relative price change occur. This is particularly true for regional economies that are, by definition, small, open and sensitive to price shocks. This paper illustrates how a measure of real income can be calculated for regional economies that takes into account relative price changes, such as terms-of-trade improvements. ¹

Real GDP captures the volume of income that is produced during a particular period, within a set of geographical boundaries, measured in terms of the product that is produced. It does not take account of the effect of changes in the relative price of traded goods on an economy's purchasing power. A broader measure of real income that encompasses real GDP, but also takes account of purchasing power changes, is necessary for understanding the evolution of economic aggregates, such as consumption, investment or imports and, ultimately, economic welfare across regions, when large traded-goods-related relative price changes occur.

The international handbook used by statistical agencies for calculating real GDP—the 1993 System of National Accounts—describes how this broader measure of real income, referred to as real gross domestic income (GDI), can be calculated. In doing so, it outlines how to go from measuring the income produced by an economy to the goods and services that the economy can purchase with that production.

To illustrate the empirical importance of understanding how relative price changes affect a country and its constituent regions, real GDP and real GDI in Canada and each of the 10 Canadian provinces is examined from 1981 to 2007. This is a period that encompasses important trade-related relative price changes for Canada, particularly during the latter part of the period, when commodity prices increased. The focus is on Canada because the Provincial Economic Accounts from Statistics Canada provide a high quality and consistent set of regional estimates. Moreover, Canada's provinces are geographically dispersed with widely differing economic structures, whose individual responses to relative price shocks can be significantly different from each other, and from the Canadian aggregate. As such, Canada provides an example of how relative price changes affect regions. While similar analysis could be performed with other large countries such as the United States, Russia or Japan, there is in practice no reason why this type of analysis could not also be applied to any group of economies, such as the European Union or the Organisation for Economic Co-operation and Development, provided that a consistent set of National Account estimates for the constituent regions exists.

The remainder of the paper is structured as follows. In Section 2, the relationship between real GDP and real GDI is discussed. In Section 3, the difference that the inclusion of the trading gain has for the Canadian and provincial economies is illustrated, and Section 4 concludes.

1 . This paper provides a measure of real gross domestic income by province but does not move to producing estimates of gross national income at the provincial level because data on inter-provincial income flows are not available (see Macdonald 2007).