The Relationship between Unemployment Rate and Economic Growth across Canada

Among the ten provinces of Canada, Quebec showed the highest unemployment rate, in April 2020 (17 %). In January and February, the province of Quebec along with Manitoba and British Columbia recorded the lowest unemployment rate in Canada. In February 2020, the level of the unemployment rate in Quebec was 4.5 %, the lowest since 1976. The extent of the spread of the COVID-19 explains the high unemployment rate in Quebec. As a matter of fact, Quebec accounts for more than half of the confirmed cases of COVID-19 in Canada (44 197 cases out of 79 502, as of May 20). Most of these cases (about half) are in the region of Montreal that generates the third of Quebec's gross domestic product (GDP).

In the Prairie Provinces (i.e. Manitoba, Saskatchewan, and Alberta), the unemployment rates in April 2020 nearly doubled, compared to their historical averages (see Figure 1). For example, in Alberta, the unemployment rate was 13.4 % in April, versus an historical average of 6.4 %. In April, the unemployment rate in Alberta was the highest in the Prairies and also a record high in the history of this province.

Figure 1: Unemployment Rates across Canada.

The picture of the situation is different in Atlantic Canada (i.e. Newfoundland and Labrador, Prince Edward Island, Nova Scotia, and New Brunswick). In Newfoundland and Labrador, the unemployment rate in April 2020 (15.9 %) was very close to its historical average (16 %). This reminds that unemployment rate has often been very high in this province. (See my blogpost Unemployment Rate in Newfoundland and Labrador.) Prince Edward Island is the only province in Canada where the unemployment rate during the outbreak of COVID-19 has been lower than the historical average. As of May 20, only 27 cases of COVID-19 have been found in this province.

Throughout Canada, three economic sectors have been mainly affected by the lockdown restrictions: (1) accommodation and food services, (2) construction, (3) forestry, fishing, mining, quarrying, oil and gas. In the sector of accommodation and food services, between January and April 2020, the unemployment rate rose from 9 % to 44.7 % in Quebec, from 2 % to 30.9 % in Manitoba, from 4.7 % to 35 % in Saskatchewan, and from 5.9 % to 38.9 % in British Columbia.

In the sector of forestry, fishing, mining, quarrying, oil and gas, between January and April 2020, the unemployment rate rose from 8.7 % to 27.9 %, in Quebec. In the construction sector, while in Quebec the unemployment rate rose from 11.3 % in January to 40.3 % in April, it only rose from 5.4 % to 14 %, in Ontario.

In a previous post [here], I have used the Okun's law to predict GDP growth from changes in unemployment rates using data for Canada as a whole. In this post, I take things a bit further by estimating the Okun's law using instead data of the ten provinces (panel data). I have kept the short-run effect of unemployment on real GDP unchanged across the provinces and allow for heterogeneity only in the intercept. (This is referred to as a least squares dummy variable model, in econometrics.)

Figure 2 shows as scatter plot the changes in the annual unemployment rates and the corresponding GDP growth rates in the ten provinces, between 1981 and 2018. The blue line in this figure represents the predictions from the Okun's law. The estimate of the short-run effect of unemployment on real GDP is -1.45, which means a 1 percentage point increase in unemployment rate causes a 1.45 % decrease in real GDP. This estimate is close to the one obtained previously using aggregate data for Canada (-1.4). But, the explanatory power of this panel data model is much higher. It explains 58.5 % of the variability in the data versus 35 % for the model that uses aggregate Canadian data.

Figure 2: Okun's Law: Percentage Point Change in Unemployment Rate and Real GDP Growth Rate, Canadian Provinces, 1981-2018.

The table below reports the predictions of the real GDP growth rates for the ten provinces for the first quarter of 2020 and April 2020.

Table: Predictions of real GDP Growth Rates for the Provinces of Canada based on a Panel Data Model.

Province	First Quarter of 2020	April 2020
Newfoundland and Labrador (NL)	1.4 %	-4.1 %
Prince Edward Island (PE)	2.3 %	-.9 %
Nova Scotia (NS)	1.6 %	-2.6 %
New Brunswick (NB)	1.9 %	-4.7 %
Quebec (QC)	.9 %	-11.2 %
Ontario (ON)	1.5 %	-2.8 %
Manitoba (MB)	1.8 %	-5.2 %
Saskatchewan (SK)	.7 %	-3.7 %
Alberta (AB)	1.9 %	-3.8 %
British Columbia (BC)	1.5 %	-3.8 %

The Okun's model that uses panel data predicts a positive real GDP growth across Canada for the first quarter of 2020. This contrasts with the predictions I made previously using the aggregate Canadian data. On the other hand, it predicts negative growth rates across Canada for April 2020. However, it is worth pointing that these forecasts do not take into account the effects of the various economic stimulus programs initiated by the federal and the provincial governments in response to COVID-19.

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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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