The Relationship between Unemployment Rate and Economic Growth in Canada

The unemployment rate in Canada rose from 7.8 % in March to 13 % in April, due to the lockdown restrictions imposed by the federal and the provincial governments to stop the spread of the COVID-19. The average unemployment rate in Canada is 8.2 %. The highest ever recorded unemployment rate in five decades (13.1 %) was in December 1982.

In the early 1980s, unemployment, inflation, and interest rates were simultaneously very high in the most developed countries. In Canada, the unemployment rate was steadily above 10 %, between May 1982 and December 1985 (on average, 11.4 %). The second episode of high unemployment period Canada experienced was in the early 1990s. Particularly, between February 1991 and October 1994, unemployment rate rose, as a result of the restrictive monetary policy that aimed at curbing the high inflation inherited from the 1980s.

Since May 11, several economies have started easing the lockdown restrictions. As a result, one can expect unemployment to decline in May and over the coming months. More and more people are returning to work, as some businesses are allowed to reopen. Unfortunately, it is not all the layoff employees that are returning to work. Some businesses failed, due to the COVID-19 pandemic. The travel bans and the physical distancing rules in effect keep affecting the sector of accommodation and food services, where the unemployment rate rose from 18.4 % in March to 34.3 % in April, this year. The unemployment rate in this sector was 6.1 % in February.

The data on the Gross Domestic Product (GDP) of Canada (i.e., the value of the wealth created by Canadian residents) over the first quarter of 2020 are not released yet. But, it is certain that GDP will fall over the first quarter of this year. To predict the extent of this decline, one can use an economic relationship known as Okun's law. Okun's law predicts a consistent relationship between changes in the unemployment rate and the real GDP growth rate. In the US, a 1 percentage point increase in the unemployment rate is said to result in a 2 % decline in the real GDP. Given that the data for the unemployment rate in Canada are already available for the first quarter of 2020 and even for the month of April, I can use them to predict the decline in the real GDP by estimating the linear relationship suggested by Okun.

Even though there has been some deviations from the Okun's law over the years, I use it to predict the changes to expect the real GDP because of its simplicity. The scatter plot in the figure below shows the percentage point change in the unemployment rate and the corresponding real GDP growth rate in Canada. The data points associated with the periods of economic expansion are in green and those associated with the periods of recession are in red. During periods of expansion and recession, the expected quarterly GDP growth rates are respectively .74 % and -1.07 %.

Figure: Okun's Law: Percentage Point Change in Unemployment Rate and Real GDP Growth Rate, Canada, 1976:Q1-2019:Q4

In the above figure, the line in black represents the predictions of the Okun's law that make no distinction between periods of expansion and recession. The short-run effect of unemployment on real GDP from this linear model is -1.2, i.e., a 1 percentage point increase in the unemployment rate results in a 1.2 % decline in the real GDP. This linear model predicts a -.14 % decline in the real GDP during the first quarter of 2020.

In the above figure, the blue segment lines represent the predictions of the Okun's law conditional on the state of the business cycle. The conditional short-run effects of unemployment on real GDP are respectively -.66 and -.29 during periods of expansion and recession. This conditional model (referred to as Markov-switching model) predicts that the real GDP fell by .99 % in Canada, over the first quarter of 2020.

The table below summarizes the predictions of the real GDP growth rate based on the Okun's law.

Table: Predictions of real GDP Growth Rates for Canada based on the Okun's Law.

Stock Exchange	First Quarter of 2020	April 2020
Linear Model	-.14 %	-5.84 %
Markov-Switching Model	-.99 %	-2.34 %

Given the various financial assistance programmes initiated by the Liberal government of Justin Trudeau (which includes the Canada emergency response benefit that provides for a maximum of 16 weeks a weekly pay of $ 500 to layoff employees), the prediction of a decline of 2.34 % in real GDP in April is more realistic.

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