I have analyzed the joint behavior of inflation and unemployment in Canada over a period of time ranging from March 2001 to December 2019 (226 months).
My interest is to find out if there is any difference in the way these two variables behave during periods of economic expansion and contraction.
This is done by fitting a two-state Markov-switching multivariate Student's t-model to the data.
The inflation and the unemployment rates have turned out to be more volatile over one state than the other.
Decoding the states shows that the most volatile one corresponds to the periods of economic contraction that the Canadian economy experienced : the early 2000s crisis, the 2009 recession, and the oil price collapse of 2015.
The volatility of the unemployment rate almost doubles during the high volatility state.
The figure below shows the densities of the inflation and the unemployment rates, and plot the marginal distributions of the fitted model.
The second panel of this figure shows that the distribution of the unemployment rate is bimodal, with its lowest peak corresponding to the periods of economic expansion.
It also appears that even though the Markov-switching multivariate Student's t-model has produced an accurate estimate of the expected value of the unemployment rate during periods of expansion, it overestimated its probability of occurence.
The estimates for the inflation rate match the actual probabilities.
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The table below reports the expected values from the fitted models.
The expected value of the inflation rate turns out to be higher during periods of expansion.
On the other hand, the unemployment rate is lower during periods of expansion and higher during periods of contraction.
| Expansion | Recession | |
|---|---|---|
| Inflation Rate | .16 % | 6.01 % |
| Unemployment Rate | .12 % | 7.28 % |
The actual correlation between the inflation and the unemployment rates is positive during periods of economic expansion (.04) and negative during periods of contraction (-.02).
This means that during periods of expansion, inflation is mostly driven by such supply-side factors as technological innovations, which lower prices and raise employment (decreasing unemployment, by so doing) at the same time.
On the other hand, when the economy is contracting, inflation is mostly driven by factors affecting the demand-side of the economy such as preference shocks.
