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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The Contribution of the Expenditure Components of GDP to its Growth in Canada and the US

Gross domestic product is the value of all the goods and services produced by the residents of a country or a region. These goods and services are consumed by households, acquired and used by businesses to produce other goods and services, and purchased by the government and the rest of the world. These various expenditures are called in the economic jargon: household consumption, private investment, government spending, and net exports.
Both the share in GDP of each of these four expenditures and their respective growth rates are important in explaining GDP growth rate. I have analyzed the behavior of these macroeconomic variables over the period 1981-2013 in Canada and the United States (US).

The average growth rate of real GDP over the sample period is .6 % in Canada and .68 % in the US. Household consumption explains 59 % of this growth in Canada and 73 % in the US.

Household Consumption – It consists of all the expenditures made by households on non-durable goods (food), semi-durable goods (clothing), durable goods (household appliances and vehicles), and services (healthcare, education). In Canada and the US, it is the most important component of GDP. Figure 1 below plots the share of consumption in GDP for both countries. This share is also known as the average propensity to consume.

Historically, the average propensity to consume is higher in the US than in Canada. At least, 61 % of the goods and services produced in the US are consumed by households whereas in Canada it is at most 57 % of the GDP that is consumed each quarter. The average propensity to consume tends to increase over time in both countries.

Figure 1: Share of Real Household Consumption Expenditure in GDP, Canada (1981:Q1-2013:Q3, Source: Statistics Canada), US (1981:Q1:20113:Q4, Source: Federal Reserve of St Louis)

Figure 2 below plot the growth rates of household consumption. 

Figure 2: Growth Rate of Real Household Consumption Expenditure, Canada (1981:Q2-2013:Q3, Source: Statistics Canada), US (1981:Q2:20113:Q4, Source: Federal Reserve of St Louis)

The average rate of growth of household consumption over the sample period is .69 % in Canada and .76% in the US. This growth is positively correlated with real GDP growth rate in both countries as one can see in the table at the end.  

Private Investment – It comprises the expenses made by firms on the acquisition of residential structures (housing), non-residential structures (offices, factories), machinery and equipment (computers, furniture), and intellectual property products (licence).

In Figure 3 below I have plotted the share of private investment expenditure in GDP. This share is also known as investment-output ratio. Canada invests a higher share of its output in the production of new goods and services than the US. The investment-output ratio is trended upward but sharply fell between 2008 and 2009 during the financial crisis Canada, the US and many other countries experienced. 

Figure 3: Share of Real Private Investment in GDP, Canada (1981:Q1-2013:Q3, Source: Statistics Canada), US (1981:Q1:20113:Q4, Source: Federal Reserve of St Louis)

Private investment is the component of GDP showing the highest growth rate.  Its average growth rate is .83 % in Canada and 1.23 % in the US.  Besides, it is the most volatile component of GDP. The standard deviation of its growth rate is 2.61 in Canada and 4.18 in the US. The values of the correlation coefficient between the growth rates of private investment and that of GDP are almost the same as those between the growth rates of consumption and GDP.
Figure 4 below depicts the evolution of the growth rate of this expenditure.

Figure 4: Growth Rate of Real Private Investment, Canada (1981:Q2-2013:Q3, Source: Statistics Canada), US (1981:Q2:20113:Q4, Source: Federal Reserve of St Louis)

Government spending – It include both government defense and non defense consumption and investment. Figure 5 plots the share of government spending in GDP. The downward trend in this share means the Canadian and the US governments are reducing over time their intervention in their respective economies. However during periods of recession (early 1980s and 1990s, 2008-2010) when private investment was falling due to uncertainty and bankruptcies, the Canadian and US government increased their spending to boost their economies.

The share of government in the economy activity has always been more important in Canada than in the US. It is a minimum of 22 % in Canada versus 18 % in the US of the goods and services produced that are acquired by the government.  

Figure 6: Growth Rate of Government Spending, Canada (1981:Q2-2013:Q3, Source: Statistics Canada), US (1981:Q2:20113:Q4, Source: Federal Reserve of St Louis)

Figure 6 below plots the growth rate of government spending.

Figure 6: Growth Rate of Government Spending, Canada (1981:Q2-2013:Q3, Source: Statistics Canada), US (1981:Q2:20113:Q4, Source: Federal Reserve of St Louis)

The average growth rates of government spending are respectively .52 % and .44 % in Canada and the US. The correlation between the growth rates of government spending and GDP is positive but very low in the two countries. It is almost nil in Canada.

Net Exports – It is the difference between the goods and services sold to the rest of the world (the exports), and those purchased from the rest of the world (the imports). Net exports are also called commercial or trade balance. Positive net exports are known as trade surplus and negative net exports are called trade deficit.

The trade balance of Canada showed surplus until the end of 2007. As for the US, its trade balance has always shown deficit except in the first two quarters of the sample, which is the first half of 1981. In the third quarter of 2006, trade deficit reached the off-peak of -5.57 % of the US GDP. 

Figure 7: Share of Net Exports in GDP, Canada (1981:Q1-2013:Q3, Source: Statistics Canada), US (1981:Q1:20113:Q4, Source: Federal Reserve of St Louis)

Figure 8 below show the behavior of the growth rate of net exports over the sample period in both Canada and the US.

Figure 8: Growth Rate of Exports and Imports, Canada (1981:Q2-2013:Q3, Source: Statistics Canada), US (1981:Q2:20113:Q4, Source: Federal Reserve of St Louis)

  Table: Dynamic Behavior of Real GDP and its Components, 

Canada (1981:Q2-2013:Q3, Source: Statistics Canada), 

US (1981:Q2:20113:Q4, Source: Federal Reserve of St Louis)