be made, in an open economy, between real income and real output. i will then review the adjustment of the canadian economy to the recent sharp rise in our terms of trade and suggest some general implications for productivity and potential output. after this, i'll say a few words about the bank of canada's new economic model, totem, and conclude with some comments on the bank's outlook for the canadian economy. productivity, terms of trade, and living standards there is no doubt that advances in productivity underpin improvements in our standard of living. however, in an open economy, real income depends not only on the volume of output, but on the trading value of that output, that is, on the terms of trade. moreover, domestic production is not the only source of income, and not all income from domestic production accrues to residents. the tendency to identify standard of living with real gross domestic product ( gdp ) per capita overlooks these important dimensions. in my view, a better indicator of the standard of living would be gross national product ( gnp ) per capita deflated by domestic demand prices. 2 by focusing on gnp rather than gdp, this measure includes canadians'earnings from abroad and excludes non - residents'income earned in canada. by see, for example, r. lafrance and l. l. schembri. 1999 - 2000. " the exchange rate, productivity, and the standard of living. " bank of canada review ( winter ) 17 - 28. a similar view has been put forward by u. kohli. 2005. " switzerland's growth deficit : a real problem - but only half as bad as it looks. " available at http : / / www. snb. ch / d / download / referate / ref _ 050304 _ koh. pdf. deflating gnp by the price index for domestic purchases rather than by the gdp deflator - the price of domestic output - it captures the terms - of - trade effect. it is instructive to compare this measure of real income with that of gdp per capita over the past 35 years ( chart 1 ). while the two measures move broadly in sync for most of this extended period, they have diverged since 2003. since then, and for the first time in 25 years, real income per capita has grown consistently faster than real output per capita. from 2002 to 2005, the average annual growth of real income per capita was 3

. 6 per cent, compared with growth in real output per capita of 1. 7 per cent. this gain in real income reflects an improvement both in our terms of trade and in the balance on cross - border investment income. the substantial rise in real commodity prices since the beginning of 2003 and the reduced prices for imported consumer goods from emerging - market economies have resulted in a significant improvement in our terms of trade, and generated large gains in real income. 3 these gains, which are reflected in higher prices for domestic output relative to those for domestic purchases, account for 1. 6 percentage points of the 3. 6 per cent annual growth in real income since 2002. in addition, current - dollar gnp has grown more rapidly than current - dollar gdp since 1999, as foreign investment income accruing to canadians has risen more than canadian investment income accruing to non - residents. this factor has contributed 0. 3 percentage points to average annual growth in real income since 2002. it reflects both the decline in canada's net international indebtedness - the result of a stream of current account surpluses in recent years - and the effect of a stronger canadian dollar on the servicing of u. s. - dollar - denominated debt. the measure of real income advocated here - gnp divided by the domestic demand deflator - is more comprehensive, more intuitive, and easier to compute than the related concept of " command gdp, " which has attracted some attention lately. command gdp takes terms - of - trade changes into account by deflating current - dollar exports by the import price index ( chart 2 ). it equals real income only when the trade balance and the current account balance are both at zero. 4 to be sure, real gdp has other drawbacks as a measure of living standards, and these drawbacks apply equally to the measure of real income derived from gnp. for example, both are measures of gross, rather than net, output or income - they don't make allowance for depreciation of capital or degradation of the environment. furthermore, they ignore non - marketed services produced by public infrastructure, and make no allowance for the distribution of income among canadians. but the point i want to highlight this evening is that improved terms of trade and a strengthened net foreign investment position have resulted in a significant - and easily measured - increase in the real per capita income of canadians in the aggregate, and thus in our standard of living. of course, the income gains generated by an