# Oxford University Press 2001 Oxford Economic Papers 53 (2001), 67±93 67

All rights reserved

The sources of unemployment in Canada,

1967±91: evidence from a panel of regions
and demographic groups

By Pierre Fortin*, Manfred Keil{, and James Symons{

* Department of Economics, Universite du QueÂbec aÁ MontreÂal, and Canadian
Institute for Advanced Research
{ Department of Economics, Claremont McKenna College, 500 E Ninth St.,
Claremont, CA 91711, USA
{ Department of Economics, University College, London, and Centre for Economic
Performance, London School of Economics

We analyze the determinants of Canadian unemployment in a framework incorporat-

ing demand and supply-side variables: the interest rate, taxation, foreign activity, mini-
mum wages, union density, demographic pressure, unemployment insurance, terms of
trade. The model is estimated with 500 observations for ®ve Canadian regions and four
demographic groups, 1967±91. We provide a comprehensive picture of the macroeco-
nomic and structural causes of unemployment with data combining the advantages of
macroeconomic time series and microeconomic cross sections. The long-term rise in
Canadian unemployment since 1960 is attributed to higher real interest rates, the UI
reform of 1972, and slightly adverse net demographic pressure.

1. Introduction
In this paper, we analyze the determinants of unemployment rates in Canada.
Understanding Canadian unemployment is highly relevant from an international
perspective because the country is North American, but has nevertheless experi-
enced European unemployment levels in recent years. Indeed, as Fig. 1 shows, from
1979 to 1993 the average unemployment rate was about 9.5% in both Canada and
the European Union compared to just 7% in the United States. Through the `90s,
US unemployment rates fell to close to 4%, widening the Canadian-US gap to
approximately 4%. This contrasts sharply with the decade 1964±73 when Canada
and the United States had the same unemployment rate of 4.5%. Indeed, Zagorsky
(1998) documents a rough parity stretching back to the 1920s, at least. There has
been much debate without consensus so far about the sources of the four-point
increase in the average level of Canadian unemployment and of the emergence of
the unemployment differential between Canada and the US from the decade 1964±
73 to the period 1979±93 (e.g. Ashenfelter and Card, 1986; McCallum 1987; Fortin,
1989; Card and Riddell, 1993; Canadian Public Policy, 1998).
68 sources of unemployment in canada

Fig. 1. Unemployment rates: Canada, Europe, US

Table 1 Canadian regional unemployment rates in the four peak years 1966, 1974,
1981, and 1989 (percentages)

Levels
................................................................................................................................................................
Atlantic Prairie British
Year Provinces Quebec Ontario Provinces Columbia Canada

1966 4.9 4.1 2.6 2.3 4.6 3.4

1974 8 6.6 4.4 3.4 6.2 5.3
1981 11.5 10.3 6.6 4.5 6.7 7.5
1989 12.3 9.3 5.1 7.3 9.1 7.5
Changes
1966/74 3.1 2.5 1.8 1.1 1.6 1.9
1981/74 3.6 3.7 2.2 1.1 0.5 2.2
1989/81 0.7 71.0 71.5 2.8 2.4 0.0
1989/66 7.4 5.2 2.5 5.0 4.5 4.1

Source: Statistics Canada, The Labour Force, Cat. No. 71±001.

Table 1 adds the Canadian regional perspective by comparing the levels and
changes of the ®ve regional unemployment rates across the last four peaks of
economic activity (1969, 1974, 1981, and 1989). Four facts stand out. First, from
the peak of 1966 to that of 1989, unemployment drifts up in every region. Second,
Ontario and the Prairie provinces always have lower than average unemployment
rates, whereas the Atlantic provinces, Quebec, and British Columbia always have
higher-than-average unemployment rates. Third, the Atlantic region not only starts
 fortin ET AL. 69

the period with the highest unemployment rate of all, but it also experiences the
most important unemployment increase from 1966 to 1989 (7.4 percentage
points). Quebec's unemployment situation deteriorates sharply between 1966
and 1981, but improves in the 1980s. Ontario's absolute position also deteriorates
from 1966 to 1989, but its relative position gets better. Fourth, the unemployment
performance of the Prairies and British Columbia seems to follow the world com-
modity cycle. These two regions did very well in 1974 and 1981, but very poorly
later in the 1980s.
These pronounced unemployment differentials across Canadian regions offer an
interesting methodological opportunity. Canadian regional data is abundant and of
the highest quality. Compared to the standard exploitation of national data, break-
ing down the Canadian unemployment experience by region brings more degrees
of freedom and a substantial amount of additional variance in variables that are
region-speci®c and are thought to in¯uence unemployment, such as minimum
wages, union density, unemployment insurance regulations, terms of trade, and
demographic pressure. The opportunity is there for improving estimation ef®-
ciency and the power of statistical tests signi®cantly.1
The use of regional macrodata within a country to study the determinants of
unemployment is also likely to be accompanied by a smaller degree of unobserved
heterogeneity than the popular reliance on cross-country macrodata. Drawing data
from one country and from an area with relatively homogeneous institutions and
attitudes weakens the argument that the results are artifacts of statistical mismeas-
urement. International comparative studies are vulnerable to that argument either
because they ignore the heterogeneity, or because they try to cope with it by intro-
ducing qualitative variables to capture such institutional country characteristics as
`union coordination', `employer coordination', `wage ¯exibility', `corporatism', etc.
(e.g. Bruno and Sachs, 1985; Newell and Symons, 1987; Layard et al., 1991). Those
measures are easy to criticize for inadequacy or circularity.
We view our disaggregated macroeconometric analysis as a useful, indeed essen-
tial, counterpart of the numerous existing microeconometric studies of unemploy-
ment. Most micro studies are concerned with unemployment duration or with the
supply side of the labour market. A few deal with unemployment incidence, or the
demand side. But their global implications and policy relevance can only be appre-
ciated at the macro level, where the partial elements, duration/incidence and
supply/demand, are combined.
Our explanation of unemployment relies on a number of factors that are thought
to operate on the demand side, the supply side, or both. The resulting model is
estimated with a panel of 500 observations for ®ve Canadian regions and four
demographic groups over the 25 years 1967±91. The purpose is to provide a
comprehensive picture of the cyclical and structural causes of Canadian unem-

..........................................................................................................................................................................
1 See Myatt (1993) for a survey of previous attempts.
70 sources of unemployment in canada

ployment with a unique data set combining the respective advantages of macro-
economic time series and microeconomic cross sections.
Because the effect of unemployment insurance on unemployment remains a
major source of controversy in the literature (see the surveys by Atkinson and
Micklewright, 1991; Bean, 1994), and because major changes in unemployment
insurance regulations have been implemented in Canada and have been considered
in other countries (e.g. Axworthy, 1994; OECD, 1994), we pay particular attention
to proper measurement and testing of UI program variables.
Our statistical results identify signi®cant effects on unemployment of US activity,
taxation, the terms of trade, the real interest rate, youth and women labour force
shares, minimum wages, and the wage subsidy provided by UI to the weakly-
attached labour force. These estimated effects enable us to give a detailed account
of the factors that led to the rise in Canadian unemployment between the peaks of
1969 and 1991. Among them, the two main sources appear to be the higher real
interest rate and the substantial increase in the UI wage subsidy following the UI
reform of 1971 and subsequent amendments. Our results also allow us to conjec-
ture that the same two factors must have been key contributors to the widening
unemployment rate differential that emerged during the 1970s and 1980s between
Canada and the United States.
The paper is divided into ®ve sections. Section 2 presents the causal model,
which is estimated and tested in Section 3. A novelty we introduce here is a Haus-
man-type test for the presence of omitted common trends in our speci®cations.
Section 4 draws the economic implications. Since this paper was ®rst written, new
data have become available, which have made it possible to conduct an out-of-
sample dynamic simulation. This is an interesting period over which Canadian UI
generosity and Canadian monetary policy have progressively converged to those of
the United States. These results are discussed in Section 5. Section 6 concludes.

2. Proximate causes of unemployment

We consider the following unemployment equation for group i and region j in
year t
uijt ˆ uij …ijt ; jt ; t † …1†
where  is a vector of group- and region-speci®c variables,  a vector of region-
speci®c variables, and a vector of Canada-wide variables. This equation can be
conceived of as resulting from a standard IS-LM-AS model, which was recently
shown by GalõÂ (1992) and Duguay (1994) to provide a reasonable empirical
description of macroeconomic relationships in the American and Canadian con-
texts. A number of structural factors that are generally thought to have an import-
ant in¯uence on unemployment are also introduced into the equation (see Bean,
1994, for a survey).
We now set out to be more speci®c about the various arguments of the unem-
ployment equation.
 fortin ET AL. 71

2.1 Macroeconomic variables

2.1.1 The real interest rate There are several avenues for the ex ante real interest
rate to in¯uence unemployment.
On the aggregate demand side, real interest rate shocks displace the economy
along the IS curve. Involved here is the direct reaction of interest-sensitive com-
ponents of consumption and investment, as well as the indirect reaction of net
exports to the accompanying real exchange rate movements. Those effects will last
only as long as the supply side takes to adjust.
On the aggregate supply side, one possible channel derives from search activity.
If the current real interest rate is high, there is an incentive for job seekers to take a
job now because the returns to investment are currently high. There does not
appear to be a great deal of empirical evidence for this line of argument. A related
conjecture is that high real interest rates could make unemployed workers more
likely to cease searching (if searching entails costs) since the returns from ®nding a
job with signi®cant rents is lower.
But this is not the only way real interest rates can in¯uence unemployment on
the supply side. A job typically has a rent that endures over time. Assume that the
current rent is subject to stochastic variation but that future rents are constant in
expectation. The employment relationship will continue if the present value of
rents is positive. If the current rent receives an adverse shock, the relationship is
more likely to cease when the real interest rate is high because the present value of
future rents is then lower. This idea is implicit in the work of Jovanovic (1984) and
has been emphasized in Newell and Symons (1991).
A different hypothesis has been put forward by Carruth et al. (1995), who argue
that a permanently higher interest rate has the economy slide toward a permanently
lower real wage along the economy's factor price frontier, which in turn increases
unemployment for bargaining/ef®ciency wage reasons. Figure 2 shows the real
interest rate for our sample period.

2.1.2 Other demand shocks In principle, one might experiment with all other
variables that condition the IS curve and affect unemployment over short- to

Fig. 2. Canadian real interest rate

72 sources of unemployment in canada

medium-run horizons in the presence of temporary nominal rigidities. Federal

spending and US economic activity are two such major in¯uences on aggregate
demand and unemployment. We also consider region-speci®c taxation and terms
of trade as demand-side variables. However, we acknowledge that these factors will
also operate on the supply side by affecting the wedge between the real before-tax
product wage and the real after-tax consumption wage.

2.1.3 Wedge shocks In most ef®ciency wage and bargaining models there is no
role for the level of the tax and terms of trade wedge between the real product wage
and the real consumption wage. In bargaining models the independence of the
aggregate unemployment rate from the level of the wedge is not a deep result in the
sense that it is derived from natural assumptions about preferences and the prin-
ciples governing the bargaining process. Rather it follows from the parameteriza-
tion of cardinal utility functions (see, e.g., Bean and Symons, 1989). There are,
however, natural avenues for changes in the wedge to in¯uence unemployment.
One might hypothesize, in a bargaining framework, that workers ®nd it costly (in
utility terms) to adjust consumption levels. Thus, after an adverse increase in the
wedge, the consumption wage would fall only slowly to its new lower equilibrium
level so that product wages would suffer a temporary increase, and unemployment
might result (Newell and Symons, 1987).
The argument of Lilien (1982) and Samson (1985) gives another plausible reason
why wedge shocks should cause increases in unemployment. An increase in the
price of output relative to the price of consumption is more likely to be associated
with large price increases in a limited number of sectors than with a uniform
increase in the price of output across all sectors. It thus follows that wedge increases
should be accompanied by reallocation of labour from contracting to expanding
sectors. In the transition it is likely that the unemployment rate should increase.
Our wedge variable is constructed from provincial consumption and production
prices, and provincial tax rates. Its terms-of-trade component is designed to cap-
ture the effects of the highly-differentiated commodity price shocks across Cana-
dian regions, particularly in the Prairie provinces and British Columbia. Note that
it is via the terms-of-trade variable that oil-price shocks will impinge on unemploy-
ment in our framework. Positive raw material price shocks tend to be benign for
the west of Canada, malign elsewhere. Figure 3 shows variations in the Terms of
Trade component of the wedge for the Prairies and Ontario. Note in particular the
difference in the time series for the OPEC episodes and the collapse of oil prices in
1986.

2.2 Structural factors

2.2.1 Demographics The ®rst potential demographic in¯uence is the growth rate
of the aggregate labour force, which might have a temporary effect on unemploy-
 fortin ET AL. 73

Fig. 3. Changes in terms of trade: Ontario and Prairie provinces

ment during some adjustment period. In our experiments though, this variable
always proved statistically negligible and we shall not discuss it further.
The second in¯uence we consider is the level share of the young population aged
15 to 24 in the regional labour force. A rise (fall) in the youth share seems to have a
protracted, and perhaps permanent, upward (downward) impact on the unem-
ployment rates of youth and competing groups of older men and women (Wachter,
1976; Foot and Li, 1987). This could come about if there were long-lasting wage
rigidities. But there are other channels. Many authors have noted the rapid
increases in wages in the OECD countries beginning in the mid to late '60s (see,
e.g., Nordhaus, 1972; Newell and Symons, 1987). This coincided with the entry into
the labour force of the baby boomers and some authors have sought to establish a
causal link. The reasoning here is that, since younger people appear to have a higher
natural rate of unemployment, an increase in their share would mean that collective
wage bargaining would take less account of unemployment consequences. There is
an interesting discussion of this in Flanagan et al. (1982).
The relative labour supply of women aged 25 and over is a third possible candi-
date for in¯uencing unemployment levels of competing groups of male and
younger workers. Wage rigidities may be important here as well, but an attractive
complementary explanation is that the rising number of working women have
enabled other household members to become more selective about jobs and to
search longer, thus permanently increasing unemployment incidence and duration.
To some extent this offers another channel for increases in youth participation to
increase the unemployment rates in other demographic groups.
There is an important methodological reason why testing for these relative
labour supply effects is crucial. It has been recently pointed out that it is extremely
dif®cult to disentangle the effect of demographic pressure from that of unemploy-
ment insurance bene®ts in empirical unemployment and real wage equations,
because in many countries these variables are all strongly trended (Rose, 1988;
Bean, 1994). We try to get around this identi®cation problem by drawing upon
cross-regional as well as temporal sources of variation in the variables.
74 sources of unemployment in canada

2.2.2 Trade unions By setting wages above market-clearing levels in some sectors,
unions may increase wait unemployment, in the context of dual labour markets.
Union density therefore belongs to our list of regressors. Since the 1960s union
density has declined sharply in the United States, but has remained high in Canada.
These diverging trends are a key element of the debate over the causes of the
Canadian-US unemployment differential that has emerged in the 1980s (e.g.
Ashenfelter and Card, 1986; Riddell, 1993).

2.2.3 Relative minimum wages The traditional view suggests that minimum wages
are also an important ingredient in unemployment equations. Increases in mini-
mum wages affect employment adversely, especially if coverage is near-universal
and the minima represent high fractions of average wages (e.g. Brown, 1988;
Castillo-Freeman and Freeman, 1992). However, Mincer (1976) has shown that
negative labour force participation effects in combination with disemployment
effects make the link to unemployment uncertain.
In sharp contrast with the traditional view, a number of authors have recently
presented evidence that minimum wage rises in the United States have had no
adverse effect on employment (e.g. Card, 1992a; 1992b; Katz and Krueger, 1992;
Card and Krueger, 1994; Krueger, 1994). In Canada, the existing evidence indicates
a positive relationship between minimum wages and unemployment rates (Fortin,
1979; Swidinsky, 1980; Schaafsma and Walsh, 1983).2 Over our sample period,
relative minimum wages rose and fell by 30 to 50% in Canadian regions. Those
large changes should help identify the effect on Canadian unemployment.

2.2.4 The unemployment insurance (UI) system We take seriously the implication
of the theory of labour supply that unemployment insurance has different effects
on strongly-attached workers and on more weakly-attached workers.
For strongly attached-workers, the classical free-choice model views the UI
replacement rate as a wage tax whose substitution and income effects both dis-
courage work. In a stochastic world with involuntary job separation and job ration-
ing, the replacement rate, adjusted for coverage, is a subsidy to search that increases
unemployment duration in most models (Johnson and Layard, 1986). Microeco-
nometric studies usually ®nd evidence of a small positive relationship between the
replacement rate and unemployment duration (see the survey by Mortensen, 1986).
However, a higher subsidy to search could also affect the frequency of unem-
ployment. On the one hand, longer search could lead to a better matching of
workers and jobs, which could reduce the incidence of future unemployment.
On the other, a higher replacement rate may, on the demand side, induce ®rms
to increase the frequency of temporary layoffs (Feldstein, 1978). The net effect of
..........................................................................................................................................................................
2
Swidinsky (1980) also points out speci®c differences between the US and Canadian system.
 fortin ET AL. 75

the replacement rate on the unemployment rate, which is the product of duration
and incidence, is therefore in doubt. It must be ascertained empirically.
For weakly-attached workers, the classical free-choice model views the wage
replacement rate (r), the minimum length of the qualifying period (min) and the
maximum duration of bene®t (max) as operating in combination to subsidize work
and induce positive labour force participation (e.g. Fortin, 1984; Milbourne et al.,
1991). The implicit wage subsidy can be substantial. Over 1972±77, in high-unem-
ployment Canadian regions, those who had worked only a minimum of eight weeks
had access to a maximum of 44 weeks of UI bene®ts, or the equivalent of
r
max ˆ 29 full-pay weeks at the replacement rate of 67%. The wage subsidy to
(unstable) employment was therefore r
…max=min† ˆ 367%. It was reduced to
252% in 1978 (with r ˆ 60%, max ˆ 42 weeks, min ˆ 10 weeks) and to 147%
in 1994 (with r ˆ 55%, max ˆ 32 weeks, min ˆ 12 weeks).
A major implication of this UI-wage-subsidy view is that increases in the subsidy
encourage the labour force participation of individuals who would otherwise leave
or remain out of the labour force and who thus experience longer and more
frequent spells of unemployment than average. Supportive evidence of the parti-
cipation effect is available from microeconomic studies (e.g. Hamermesh, 1980). It
also agrees with the macroeconomic observation by Card and Riddell (1993) that
Canada and the United States had about the same employment/population ratio
but that, consistent with its more open UI program, Canada had a higher labour
force participation rate (and therefore a higher unemployment rate).
The wage-subsidy view extends to situations of Keynesian unemployment and
job rationing. In this context, the higher r
…max=min†, the more workers with bad
job prospects will prefer holding short-duration jobs followed by long spells on UI
to leaving the labour force and falling on welfare. A clear implication is that
unemployment insurance would magnify the multiplier effect of any exogenous
disturbance on unemployment.
Accordingly, our empirical investigation incorporates two dimensions of the UI
bene®t system: the coverage-adjusted wage replacement rate for the strongly-
attached workers, and the wage subsidy for the more weakly-attached (or rationed)
workers. We test their empirical signi®cance with some help from the major
amendments to the Canadian UI Act that took place in 1972, 1978, and 1990±
91, and from the important amount of variation in regional min and max owing to
their connection with local unemployment rates starting in 1978. Figure 4 shows
the weighted aggregate UI generosity variable.

3. Econometric results
We estimate an unemployment equation of the form
uijt ˆ ij ‡ ij xijt ‡ "ijt …2†
with 500 observations on 4 demographic groupings (i ˆ older men 25 and over,
older women 25 and over, younger men 15 to 24, and younger women 15 to 24),
76 sources of unemployment in canada

Fig. 4. Unemployment insurance generosity

®ve regions (j ˆ Atlantic provinces, Quebec, Ontario, Prairie provinces, and British
Columbia), and 25 years (t ˆ 1967 to 1991). For each of the 20 demographic-
regional ij cells there are 13 regressors: the constant and the 12 right-hand variables
included in x. The latter are lagged unemployment and the 11 explanatory variables
discussed in the previous section. Overall, 260 parameters are involved: 20 coef®-
cients ij , and 240 coef®cients in the ij vectors.
We assume the error terms "ijt to have contemporaneous covariance matrix .
Our estimation is therefore done by Zellner's seemingly-unrelated-regression
(SUR) method. Most of our testing compares the residual sum of squares between
restricted and unrestricted models (Gallant and Jorgenson 1979). When the equa-
P 1=2
tions are weighted by an estimate of , the difference between these sums of
squares is asymptotically chi-square (with degrees of freedom equal to the number
of restrictions) under the null hypothesis.
The appendix gives the de®nitions and sources of the variables and explains the
instrumenting procedures we have employed to purge them of endogeneity when
appropriate. It is particularly important to address the problem of endogeneity
of the UI program parameter max/min owing to its dependence on the current
regional unemployment rate in the 1978±91 subperiod.
In the unemployment equation, the interest rate, federal spending, US activity
and the UI replacement rate are national variables. Taxation, the terms of trade, the
youth share, the women share, union density, the minimum wage, and the UI wage
subsidy are region-speci®c. The constant and the lagged unemployment rate alone
are group-and-region speci®c.

3.1 Tests of homogeneity across regions

Our initial estimation results with the large 260-parameter model showed that
demographic heterogeneity is much more important than regional heterogeneity.
 fortin ET AL. 77

We therefore tested, separately for each demographic group j, the hypothesis that
all parameters ij (but not the regression constants ij ) are identical across regions
i. Thus, for each of the four sets of 65 parameters pertaining to a demographic
group, 48 regional equality restrictions were tested (four regional equalities for each
of the 12 tested variables).
Under the null of parameter constancy, the difference between the weighted
residuals from the constrained and unconstrained SURs is in each case distributed
asymptotically as chi-square with 48 degrees of freedom. These two regressions are
based on the same estimate of the covariance matrix , obtained under the null of
parameter constancy. This is desirable because, in any single regional equation, the
number of regressors (13) is large relative to the number of annual observations
(25) so that large biases in estimates of error variance are certain if the parameters
of  are freely estimated. The outcome was that three of the four sets of restrictions
easily passed the test at the 5% level: for younger men and women and for older
men. For older women, the restrictions were rejected just at the 1% level.
For the case of older women, we found that imposed constraints increased the
regression standard errors (adjusted for degrees of freedom) by about 13% across
regions on average, somewhat more than the 10% proposed by Ohta and Griliches
(1975; p. 339) as a rule of thumb for maximum deterioration of ®t. In contrast, the
corresponding errors for older men, for example, deteriorated by only about 4% on
average for the restricted equations. Examination of coef®cients seemed to suggest
that the principle parameter varying across regions was the lagged dependent vari-
able. A possible interpretation of this is that the causes of changes in female
participation over this period, which we had hoped to proxy by the share of
older women in the labour force, have ¯owed at different rates over the regions
of Canada. We shall return to this issue below.

3.2 Characteristics of the constrained equations

The estimated equations with regional homogeneity imposed are reported in Table
2. A number of results stand out. Depending on the demographic group, the effects
of federal spending are either negligible, as predicted by the Mundell±Fleming
model under ¯exible exchange rates, or (in the case of older women) wrong-
signed. This may be due to the dif®culty of extracting a truly exogenous component
of spending. Taxation and terms of trade enter more or less with equal and oppo-
site signs. This suggests the in¯uence of these two variables may be summarized as
the wedge between the real consumption wage and the real product wage. Finally,
the calculated effects of the change in the UI wage replacement rate are economic-
ally negligible. This result is consistent with those of existing microeconometric
studies (Bean, 1994). UI would affect unemployment mostly through the wage
subsidy variable.
We are thus led to add three further restrictions on the model with regional
homogeneity: federal spending and the UI replacement rate are deleted, and the
wedge restriction is imposed. This gives the ®nal estimated model in Table 3.
78 sources of unemployment in canada

Table 2 Estimated unemployment equations, four demographic Groups, Canada,

1967±1991
Demographic Groups
................................................................................................................................................................
Right-hand variable Men 25+ Women 25+ Men 15±24 Women 15724

lagged unemployment rate 0.611*** 0.668*** 0.603*** 0.646***

(0.062) (0.061) (0.048) (0.061)
lagged real interest rate 0.198*** 0.149*** 0.304*** 0.184***
(0.040) (0.031) (0.062) (0.068)
lagged change in 0.022 0.046*** 0.048* 0.016
federal spending (0.021) (0.016) (0.032) (0.035)
US activity shock 70.130*** 70.010 70.406*** 70.330***
(0.040) (0.031) (0.064) (0.066)
lagged change in taxation 0.071** 0.117*** 0.170*** 0.105*
(0.036) (0.035) (0.057) (0.069)
lagged change in terms of trade 70.057*** 70.012*** 70.162*** 70.139***
(0.019) (0.022) (0.032) (0.039)
youth share of labor force 0.022** 0.031*** 0.091*** 0.057***
(0.009) (0.009) (0.015) (0.018)
women share of labor force 0.022** 0.025** 0.065*** 0.059***
(0.011) (0.011) (0.018) (0.021)
union density 0.052* 0.048 0.113* 0.068
(0.033) (0.040) (0.071) (0.062)
relative minimum wage 0.003 0.013* 0.006 0.046***
(0.008) (0.008) (0.015) (0.013)
UI replacement rate 70.012 70.006 70.009 70.035*
(0.014) (0.013) (0.020) (0.026)
UI wage subsidy 0.010** 0.013** 0.011 0.026***
(0.060) (0.006) (0.009) (0.011)
proportion of variance explained 0.60±0.82 0.40±0.77 0.70±0.95 0.51±0.74
of changes in unemployment rate
standard error of regression 0.005±0.010 0.004±0.008 0.005±0.017 0.009±0.012
absolute value of Durbin's 0.16±2.67 0.29±2.26 0.03±3.15 0.21±1.78
h7statistic

Note: The left-hand variable is the aggregate unemployment rate of the relevant demographic group and
region. The right-hand variables are de®ned in the Appendix and discussed in the text. For each
demographic group, the set of 5 regional equations is jointly estimated by Zellner's seemingly-unre-
lated-regressions method (SUR) with the 125 annual observations (®ve regions  25 years). In each set,
region-speci®c constants have been estimated (but are not reported), and the coef®cients of every right-
hand variable have been constrained to be equal across regions (the coef®cients reported are these
common slopes). The numbers in parentheses below the estimated coef®cients are their associated
standard errors. Stars indicate rejection of the hypothesis of parameter nullity at the usual 10% (one
star), 5% (two stars), and 1% (three stars) signi®cance levels of the one-tail test, respectively. The
numbers reported for the three summary statistics are the ranges observed across regions for each set
of demographic equations.
Source: Authors' calculations.
 fortin ET AL. 79

Table 3 Estimated unemployment equation, four demographic groups, Canada,

1967±1991
Demographic Groups
................................................................................................................................................................
Right-hand variable Men 25+ Women 25+ Men 15±24 Women 15±24

lagged unemployment rate 0.644*** 0.689*** 0.621*** 0.702***

(0.055) (0.054) (0.044) (0.048)
lagged real interest rate 0.199*** 0.167*** 0.311*** 0.167**
(0.041) (0.033) (0.064) (0.067)
US activity shock 70.141*** 70.022 70.426*** 70.333***
(0.040) (0.032) (0.063) (0.064)
lagged change in the wedge 0.058*** 0.094*** 0.147*** 0.132***
(0.016) (0.017) (0.027) (0.033)
youth share of labor force 0.018** 0.022** 0.079*** 0.048***
(0.009) (0.009) (0.014) (0.017)
women share of labor force 0.017** 0.012 0.051*** 0.048**
(0.009) (0.010) (0.017) (0.019)
union density 0.047* 0.036 0.113* 0.064
(0.032) (0.039) (0.070) (0.062)
relative minimum wage 0.004 0.015** 0.005 0.038***
(0.008) (0.008) (0.015) (0.013)
UI wage subsidy 0.007** 0.014*** 0.010** 0.014***
(0.003) (0.002) (0.005) (0.005)
Proportion of variance explained 0.62±0.82 0.40±0.74 0.69±0.95 0.51±0.71
of changes in unemployment rate
Standard error of regression 0.005±0.010 0.004±0.009 0.005±0.170 0.009±0.120
Absolute value of Durbin's 0.05±2.50 0.21±2.05 0.05±4.91 0.05±1.49
h±statistic

Note: The note to Table 2 applies. The above model is the same as that of Table 2, except that zero
constraints are now imposed on (i) all coef®cients of the federal spending shock; (ii) all coef®cients of
the UI replacement rate; and (iii) the sums of the coef®cients of the changes in taxation and in the terms
of trade (yielding one coef®cient for the change in the wedge).
Source: Authors' calculations.

The equations of Table 3 account for about 90% of the variance of unemploy-
ment across regions. A more informative measure of ®t is the explained proportion
of the variance of changes in unemployment: in Table 3 this is between 40 and 95%.
The standard errors of the regressions range between 0.4 and 1.7 percentage points
of unemployment. Durbin's h-statistic suggests important serial correlation in four
of the 20 demographic-regional cells. Two of these four occur in equations for
Ontario. This could be a sign that the regional homogeneity restriction is a bit too
strong in this particular case. Investigation of this problem is left for future work.

3.3 Speci®cation tests for omitted Canada-wide trends

Before we examine the economic implications of these results, we want to address a
®nal statistical concern. The parameter estimates of Table 3 are open to the objec-
tion that they are biased by omitted variables, in particular omitted Canada-wide
80 sources of unemployment in canada

trends. Inspection of the data (Fig. 1) shows an upward trend in the Canadian
unemployment series between the mid-1960s and the 1980s. Several of our regres-
sors, such as the youth share, the women share, union density, the minimum wage,
and the UI variables, have some sort of trend associated with them. If, in truth,
there are important excluded trends, be they even changes in Weltanschauung, then
the correlation between the explanators and the omitted variables will create such
biases.
We can test for this phenomenon by exploiting the panel nature of the data,
provided we are willing to assume that the trends are Canada-wide. For this
purpose, we add to eq. (2) four sets of 24 year-speci®c dummies jt (one set for
each demographic equation j). The new equation is
uijt ˆ ij ‡ j xijt ‡ jt ‡ "ijt …3†
Here, we have imposed constancy of the parameter vectors ij across regions, thus
dropping the regional subscript i from these vectors. What we have then, for each j,
is a two-way ®xed effects model that is standard in panel data analysis (e.g. Greene,
1993). For (3) to be identi®ed, the two Canada-wide variables, namely the interest
rate and the US activity shock, must be withdrawn from the x vectors. Instead of
nine variables as in Table 3, x now includes only seven region-speci®c variables:
lagged unemployment, the change in the wedge, the youth share, the women share,
union density, the minimum wage, and the UI wage subsidy. Note that eq. (3) can
be expressed in terms of deviations from the mean
uijt ujt ˆ ij j ‡ j …xijt xjt † ‡ "ijt "jt …4†
where the year dummies jt have cancelled out.
Now denote by bj1 the SUR estimate of j based on the version of eq. (2) that
constrains ij ˆ j for all i and allows no year dummies. Denote by bj2 the SUR
estimate of j based on eqs (3) or (4), where ij ˆ j is again imposed and, this
time, year dummies are allowed. Then, under the null hypothesis of no omitted
trends, bj1 and bj2 are two consistent estimators of j , with bj1 the more ef®cient of
the two. Under the alternative hypothesis of omitted trends, bj2 is still consistent,
but bj1 is not.
In this familiar situation, a Hausman speci®cation test (Hausman, 1978) can be
performed with the statistic z ˆ c 0 V 1 c, where c is the difference bj1 ± bj2 and its
covariance matrix V is the difference between the covariance matrices Vj2 and Vj1 of
bj2 and bj1, respectively. The test statistic z follows a chi-square distribution with K
degrees of freedom, where K is the common dimension of bj1 and bj2. In the present
case, with the Canada-wide variables not counted, we have K ˆ 7.
To implement this test in our SUR framework, we ®rst obtain an estimate of the
contemporaneous error covariance matrix  by single equation methods applied to
the constrained version of eq. (1). An estimate of the corresponding error covar-
iance matrix of eq. (3) is then calculated as AA 0 , where A is the matrix that
subtracts provincial averages. Equations (1) and (3) are then estimated by SUR
employing weighting matrices  1=2 and …AA 0 † 1=2Š , respectively. The device of
holding ®xed the covariance matrix  across the two estimations ensures that the
 fortin ET AL. 81

estimated covariance matrix V ˆ Vj2 Vj1 of c ˆ bj1 bj2 is indeed positive de®n-
ite. This need not be the case if each estimation were allowed to select its own
weighting matrix, whereupon the small sample properties of the test statistic would
not be well-behaved.
The outcome is that for the two groups of men and for younger women the test
is passed at the 15% level, while for older women it is failed at the 2.5% level. The
point estimates of (4) tend to be more diffuse than those of (2) particularly for the
share variables, which re¯ect Canada-wide phenomena and rely in large part on the
variance of this common component to identify the parameter with precision.
The implication is that missing Canada-wide trends are not a problem with three
of the four demographic groups, but are a problem for older women. A comparison
of the differences in the estimates between eqs (2) and (4) for the last group
suggests that the minimum wage parameter is much lower with time dummies.
To some extent this is true of the demographic variables. Our interpretation is that
the inference that minimum wages have a signi®cant effect on older women's
unemployment may be unsound. On the other hand, the key UI Wage Subsidy
variable is somewhat larger in (4).

4. Economic implications
We now discuss the economic implications of the results we have reported in Table 3.

4.1 Unemployment persistence

First, there is a fair amount of persistence in the unemployment process. Some
indirect Phillips curve estimates put the degree of unemployment persistence at
around 50% per annum in the United States (Franz and Gordon, 1993) and 85% in
Canada (Fortin, 1991). They receive con®rmation from the more direct point
estimates of persistence we report from our regional-demographic reduced forms
for Canadian unemployment in Table 3, which range between 62 and 70% per
annum. Unemployment is a viscous phenomenon.
Recently, Milbourne et al. (1991) have stressed the contemporaneous feedback
from unemployment to the UI wage subsidy as a potentially important source of
unemployment persistence. This feedback arises because since 1978 the minimum
qualifying period (min) and the associated maximum bene®t duration (max) have
been set as decreasing and increasing functions, respectively, of the local unem-
ployment rate (with only a two-month lag). This has made the UI wage subsidy
itself (r  max=min) an increasing function of the unemployment rate.
The point made by these authors is theoretically valid. If the sensitivity of
unemployment to the wage subsidy in the unemployment equation is 1 and the
sensitivity of the subsidy to unemployment according to UI regulations is 2 , then
it is a simple logical implication that the autoregressive coef®cient in the unem-
ployment equation is magni®ed by the factor 1=…1 1 2 ).
The practical question is how large this factor is. We calculate from our unem-
ployment equations in Table 3 that the Canadian average for 1 is 0.01, and from
82 sources of unemployment in canada

UI regulations that 2 was 0 until 1977, was raised to 7.0 in 1978±89, and has been
reduced to 4.0 in 1990±94. The magnifying factor therefore reached its maximum
in 1978±89, when it was equal to 1=…1 0:01  7:0† ˆ 1:075. It would have
in¯ated the average value of the autoregressive coef®cients in Table 3 from 0.66
to 0.71. This phenomenon is clearly not of suf®cient importance to account for
post-recession unemployment persistence in Canada over 1983±88 as Milbourne et
al. have claimed.

4.2 Unions, foreign activity, and the wedge

Concentrating on point estimates, our results suggest that unions increase the
unemployment rates of all demographic groups, particularly for younger workers.
The Canada-wide response to an increase of 10 percentage points in union density
is estimated to be an increase of about 1.5 percentage points in the unemployment
rate. This is close to the 1.2 point increase found by Summers (1986) with US state
data. That said, the standard errors around these estimates are quite large, leaving
much uncertainty about the exact effect. Summers' results suffer from similar
imprecision, as noted by Sims (1986). To complete the picture, it must be observed
that our measure of union density has remained basically unchanged in Canada (at
around 29%) in the last 30 years. Therefore, no part of the change in structural
unemployment can be attributed to this phenomenon.
Both foreign activity and changes in the wedge have an important, albeit tran-
sitory, effect on unemployment. A drop of 5% in US activity relative to trend raises
the unemployment rate of older men by 0.7 point and that of younger people by 1.9
points on impact. A ®ve-point increase in the wedge (which could come about by
global effective tax rate increases, or terms of trade deterioration) would raise
aggregate unemployment by about 0.4 percentage point in the short run. In all
three cases (union, foreign activity, and wedge changes) young workers are more
affected than mature workers.

4.3 Interest rates, demographic pressure, and minimum wages

The real interest rate, the two demographic variables, the relative minimum wage,
and the implicit wage subsidy provided by UI to weakly-attached (or rationed)
workers all seem to have important and persistent effects on the unemployment of
most demographic groups. In our judgment, these are the main driving forces
behind the long-term trends in Canadian unemployment since the 1960s, given
that UI generosity has returned to approximately its pre-liberalization level. We
calculate their long-term multiplier effects taking into account the autoregressive
coef®cients reported in Table 3 and, where applicable, the contemporaneous feed-
back of unemployment on the UI wage subsidy we noted above.
Each 100-basis-point increase in real short-term interest rates pushes the aggre-
gate unemployment up by 0.2 point on impact and by 0.6 point permanently. The
short-run mechanism probably combines the standard effect on consumption and
investment, as well as the indirect effect on net exports through the real exchange
 fortin ET AL. 83

rate reaction. The sources of the long-run effect, on which we have speculated in
Section 2, are less obvious. But the effect is present, as in other countries, and it
seems very strong whatever the causes of higher interest rates. There was an import-
ant upward drift in world interest rates from the 1970s to the 1980s, but large
increases of Canadian real interest rates above world levels were also observed in
the early and late 1980s. In Canada, ex ante real short-term interest rates averaged
2% in the 1960s and 6.5% in the 1980s. This increase alone was, according to our
estimates, responsible for a 2.5-point trend rise in the aggregate unemployment rate
between the two decades.
We calculate that 10% increases in the youth share and in the older women share
add about 0.8 and 0.6 percentage points to the aggregate unemployment rate,
respectively. Over the last 30 years, the youth share of the Canadian labour force
has declined from 25% to 17%, while the older women share has risen from 21% to
37%. These two opposite trends have added 0.5 percentage point on net to unem-
ployment.
Increases in provincial minimum wages seem to raise unemployment rates.
Using the point estimates from Table 3 we ®nd that a general 10% hike would
increase the aggregate unemployment rate by 0.3 point. Minimum wages impinge
mostly on women: a 10% hike would increase the unemployment rates of younger
and older women by 1.3 and 0.5 percentage points, respectively. This concords with
the fact that over two thirds of Canadian minimum-wage workers are women of all
ages.3 Similar results for Canada were found by Swidinsky (1980), Schaafsma and
Walsh (1983), and Coe (1990) and most of the traditional minimum wage litera-
ture.
Historically, minimum wages in Canada rose to 49% of average manufacturing
wages in the mid-1970s, from 40% in the mid-1960s. This would have increased the
national unemployment rate permanently by 0.7 point. After 1976, the minimum-
to-average ratio fell sharply to 35% (below the mid-1960s level) at the turn of the
1990s. Thus, over the entire sample period, we estimate that minimum wage vari-
ations have reduced equilibrium unemployment slightly, by 0.6 point.
Our results for minimum wages are in accord with the traditional view that
increases in these lead to higher unemployment, especially for younger people.4
While the New Minimum Wage literature typically focuses on employment effects
in low wage industries of fairly modest changes in the minimum wage, the changes
in the minimum wage we study are an order of magnitude higher. We combine
advantages of both time series and cross section here: relative minimum wages vary
over time relative to other wages, because of both frequent changes in the mini-
mum wage and changes in other wages, and because of inter-provincial differences.
Similar to Neumark and Wascher (1992) and Williams (1993) we have added a new

..........................................................................................................................................................................
3
This result is opposite to US studies (Mincer, 1976; Ragan, 1977).
4
For a survey of this literature see, e.g., Brown, 1988; Brown et al., 1982; Wellington, 1991.
84 sources of unemployment in canada

dimension to the purely time series or case study dimension.5 Finally, the theor-
etical foundations of positive employment effects have not been worked out well so
far, with monopsonistic explanations typically only able to tell part of the case story
(Card and Krueger, 1993; but see also Dickens et al., 1994; Neumark and Wascher,
1994).

4.4 The UI wage subsidy

There are positive and signi®cant effects of the UI wage subsidy on the unemploy-
ment rates of all demographic groups.6 The fact that these effects are particularly
strong for women agrees with similar results obtained by Corak (1992) based on
administrative microdata.
One way of appraising the quantitative importance of the estimated elasticities is
to measure the impacts on unemployment of the liberalization of 1972 and of the
1978 and 1990±94 rollback amendments. The Mackasey reform of 1972 (arising
from the 1971 UI Act) raised the average UI wage subsidy to 242%, from just 43%
in previous years. The Cullen amendments of 1978 lowered the subsidy to 166%.
Finally, the McDougall amendments of 1990, the Valcourt amendments of 1993
and the Axworthy amendments of 1994 cumulatively brought the subsidy down to
72%, close to US levels.
Our results imply that, relative to the pre-1972 situation, the impact of the UI
wage subsidy on the national unemployment rate was 2.7 percentage points after
the 1972 changes, down to 1.9 points after the 1978 amendments, and down further
to only 0.6 point after the 1990±94 amendments. We note that our calculations
exogenize the labour force weights, which likely leads to some underestimation of
the true effects. The issue of the UI impacts on labour force participation is an
important one, which future work will have to address directly.

5. Out-of sample performance

This paper was originally written in 1996 with data up to 1991. Since that date,
Canadian real interest rates have steadily fallen and, following a series of amend-
ments in 1990, 1994, and 1996, unemployment insurance generosity was eventually
reduced to approximately pre-'70s levels. Thus our model will predict a substantial
fall in Canadian unemployment over the '90s.
We are unable to extend our complete data set into the late '90s, as Statistics
Canada's data for union density after 1992 is not yet available. However, this
variable has probably not changed very much and, assuming it remains constant,

..........................................................................................................................................................................
5
The Neumark and Wascher (1992) study has been criticized by Card et al. (1993), but, as Neumark and
Washer's reply (1993) shows, the matter is far from settled. See also Williams (1993).
6
Eliminating the UI replacement variable from Table A1 left the coef®cients of the UI wages subsidy
variable largely unchanged in Table 2. This suggests that the collinearity between the two UI program
variables (due to the presence of the replacement rate in both) did not contaminate the coef®cients.
 fortin ET AL. 85

we have extended our data to 1997 and performed an out-of-sample simulation of

Canadian aggregate unemployment rates from 1992 to 1997. Figure 5 displays the
results of the static simulation.
Though we predict well the direction of change year on year, in 1997 our
estimate of the aggregate unemployment rate is one percentage point too low,
being 8.2% against an out-turn of 9.2%. As can be expected, the RMSE of the
dynamic simulation is larger. Arithmetically, the reason appears to be that the
economy is currently responding much more weakly to UI and interest rate cuts
than the model predicts.
Comparison with the US demonstrates the dif®culties associated with the UI and
real interest rate account of current Canadian unemployment problems. As we
write in 2000, both variables are very similar in the two countries, whereas unem-
ployment is perhaps 2.6% lower in the U.S., 4.0% versus 6.6%. Thus approximate
unemployment rate parity has not yet been re-established, although the unemploy-
ment rate gap has fallen by 12 percentage point over the last year.
We are not alone in reproducing over-optimistic forecasts of Canadian economic
activity in the '90s. Bank of Canada researchers found that their output equation,
estimated by Duguay (1994) up to 1990, severely over-predicted output in the
1991±96 period, being fully 12% too high in 1996 (Freedman and Macklem,
1998; see also OECD, 1998). They argue that the period was characterized by
intensive and disruptive restructuring not allowed for in their model (nor ours).
One possible explanation of the sluggish response of the Canadian economy to
the changed UI environment is that agents need to experience unemployment to
gain an accurate picture of its costs and bene®ts, as argued by the OECD (1994)
and by Lemieux and MacLeod (1998). This could generate long lags in adjustment
to changed UI, but the problem is that such learning should take place faster when
unemployment is high, as in the '90s, than when unemployment is low, as in the

Fig. 5. Out-of-sample simulation

86 sources of unemployment in canada

'70s. On the other hand, the required asymmetric response could be attained if the
propensity to be unemployed is an acquired taste, as in the addiction hypothesis
also proposed by Corak (1993).
It is also possible that the demonstrated willingness of the Bank of Canada to set,
from time to time, nominal interest rates 10 points or more above the in¯ation rate
may have induced employers to behave more cautiously. Indeed, it is dif®cult to see
how this could not be so. In that case, the increased volatility of real interest rates
led to a rise in the uncertainty of the economic environment in the 1990s. Other
candidates are the international monetary instability, the political uncertainty sur-
rounding the 1995 Quebec referendum, and perhaps the lingering ®scal concerns.
Canada seems overdue for a substantial fall in its relative unemployment rate.
Similar to the US in general culture and demography, it now has a similar UI
regime and similar monetary conditions. We can see no reason it should not have,
in due course, similar unemployment rates.

6. Conclusion
This paper aims at making two contributions to the analysis of the sources of
unemployment in Canada: one methodological, and the other substantial.
Our methodology exploits the information contained in Canadian macroeco-
nomic times series for 20 regional-demographic groups (®ve regions and four
demographic groups). Compared to studies based on national macrodata, it
takes advantage of the substantial additional variance provided by this regional-
demographic disaggregation to increase estimation ef®ciency and statistical power.
Compared to cross-country macro studies, it most likely minimizes the degree of
unobserved heterogeneity. And compared to partial micro studies, it allows full
quantitative appreciation of general equilibrium effects.
On substance, we analyse the unemployment consequences of a large set of
macroeconomic variables and structural factors: the real interest rate, US activity,
taxation, the terms of trade, the youth and women shares of the labour force, union
density, minimum wages, and two UI program parameters (the wage replacement
rate for the strongly-attached labour force and the implicit wage subsidy for the
weakly-attached labour force). Seven of these in¯uences are region-speci®c.
Our model of unemployment is implemented econometrically by application of
Zellner's seemingly-unrelated-regressions method to the 500 annual observations
of regional-demographic data for the 25-year period 1967±91. We perform two
general tests: a test of coef®cient homogeneity across regions and a speci®cation test
for omitted Canada-wide trends. Both tests are passed easily by older men, younger
men and younger women, and marginally by older women. We ®nd that federal
spending shocks and the pure UI replacement rate have negligible effects on unem-
ployment. The former result is consistent with the theoretical prediction of the
Mundell±Fleming model under ¯exible exchange rates. The latter result agrees with
those of comparable microeconometric studies. We also ®nd that taxation and the
terms of trade can be combined into a single wedge variable. Finally, we estimate
 fortin ET AL. 87

positive impacts of union density on unemployment, but the variances around

these estimates are large, leaving much uncertainty about the exact effects (includ-
ing the possibility of zero effects).
We are able to identify seven major contributing factors: US activity shocks,
changes in the wedge, the real interest rate, the youth and women labour force
shares, minimum wages, and the UI wage subsidy. The ®rst two factors, US activity
shocks and changes in the wedge, have strong, but transitory effects on unemploy-
ment. The last ®ve (including the real interest rate) impinge signi®cantly and
permanently on unemployment.
All these variables operate on unemployment with an average lag of about two
years: the adjustment to equilibrium is slow. However, taking account of the two-
way interaction between unemployment and the UI wage subsidy, we are able to
reject decisively the Milbourne±Purvis±Scoones conjecture that the Canadian UI
system tends to slow down recoveries signi®cantly.
We simulate the following long-term contributions from the ®ve above variables
to the 4.1 percentage point increase in the aggregate unemployment rate between
the cyclical peaks of 1966 and 1989: higher real interest rates ‡2:5 percentage
points, decrease in the youth share of the labour force 3:3 points, increase in
the women share of the labour force ‡3:8 points, lower minimum wages 0:6
point, and higher UI wage subsidy ‡1:9 points. On net, the calculated effect on the
permanent unemployment rate is a 4.3 point increase, which is close to the 4.1
point increase we set out to explain.
We cannot offer a similar account for the pre-1990 2.5-point widening of the
Canadian-US unemployment rate differential that occurred over the same period
without having examined the US evolution in detail. But it seems clear from our
results as well as from those of others (e.g., Card and Riddell, 1993) that the greater
openness of the Canadian UI system has played an important role. Given the
similar evolution of demography and minimum wage regulations in the two coun-
tries, other phenomena, such as perhaps the larger increase in real interest rates in
Canada and the sharp decline in union density in the United States, must also have
had an impact.
Future work will have to address this question directly with US data, as well as
others that our study leaves open: the particular unemployment behaviour of older
women, the nature and channels of the permanent effect of the real interest rate on
unemployment, and the joint behaviour of unemployment and labour force parti-
cipation. Finally, time will tell whether the current failure of Canada-wide unem-
ployment rates to respond as vigorously to policy changes as the model predicts is
just a question of variable policy lags.

Acknowledgements
We thank Daron Acemoglu, Kelly Bedard, Richard Blundell, Ken Burdett, Pierre-Yves CreÂ-
mieux, Mario Fortin, Ron Kneebone, Thomas Lemieux, Lawrence Marsh, John McCallum,
Tony Myatt, Lars Osberg, JoÈrn-Steffen Pischke, Paul Storer, Marc Van Audenrode, Ging
88 sources of unemployment in canada

Wong, Jeff Zabel, and members of the Economic Growth and Policy program of the Cana-
dian Institute for Advanced Research (particularly George Akerlof, Rick Harris, Peter Howitt
and Paul Romer), two anonymous referees, and an editor of this journal for helpful sugges-
tions and advice. The ®nancial support of the CIAR and Claremont McKenna College is
gratefully acknowledged.

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Data appendix
This Appendix gives the de®nitions and sources of the variables in the models of Tables 2
and 3 and explains the instrumenting procedures we have employed to purge them of
endogeneity when appropriate. Unless otherwise indicated, the data have been constructed
from basic data available in Statistics Canada and Bank of Canada publications. The latter
have been extracted from Statistics Canada's CANSIM databank.
The panel consists of 500 observations made of 25 years of macrodata (1967±1991) for 20
regional-demographic cells. There are four demographic groups (men 25 and over, women
25 and over, men 15 to 24 and women 15 to 24) and ®ve regions (the four Atlantic
provinces, Quebec, Ontario, the three Prairie provinces, and British Columbia). The unem-
ployment rate is speci®c to the regional-demographic cell. Seven variables are region-speci®c:
taxation, the terms of trade, the youth and women shares of the labour force, union density,
minimum wages, and the UI wage subsidy. The other four variables are national in scope: the
real interest rate, primary federal spending, US activity, and the UI wage replacement rate.
Unemployment rate: Percentage of the labour force who are not employed, calculated
from region- and group-speci®c employment and labour force data.
92 sources of unemployment in canada
Real interest rate: Real ex ante short-term interest rate (percentage). This is equal to
log …1 ‡ R† log PY1 ‡ log PY, where R is the three-month interest rate on prime corporate
paper, PY the current GDP de¯ator, and PY1 the one-year-ahead expected GDP de¯ator. In
the de®nition of the lagged real interest rate that is used as a right-hand variable, log PY1 is
projected from a regression of log PY on two lags each of itself, the average (log) hourly
manufacturing wage, the (log) food price index and the national unemployment rate.
Federal spending: Logarithm of the ratio of high-employment federal primary spending
(on goods, services, and transfers) to trend GDP. In the de®nition of high-employment
spending, unemployment insurance payments are adjusted by the ratio of some high-
employment unemployment rate (set at 7%) to the actual unemployment rate. Trend real
GDP is obtained by interpolation through values of actual real GDP in peak years 1966,
1974, 1981, and 1989. Trend GDP is the product of trend real GDP and the GDP de¯ator.
The lagged change of the resulting (log) ratio is used as a right-hand variable.
US activity shock: Residuals from a regression of (log) US real GDP on two trends, one
starting in 1959 and the other in 1968, for the sample period 1959±92. No additional trend
break is signi®cant over 1972±89. Real GDP data are from the Economic Report of the
President.
Taxation: Regional tax rate (percentage). It is equal to log …1 ‡ TF† log …1 TW†‡
log …1 ‡ TI†, where TF is the ®rm's payroll tax rate, TW the worker's payroll and personal
tax rate and TI the indirect tax rate. The three component tax rates are de®ned as follows

TF ˆ …CW ‡ …7=12† CU ‡ …12† CP†=WS

TW ˆ ……5=12† CU ‡ …12† CP†=WS ‡ PIT=PI

TI ˆ …IT SUB†=…GRP IT ‡ SUB†

In these equations, CW, CU, and CP are the regional contributions to workmen's compen-
sation, unemployment insurance and Canada/Quebec Pension Plans, respectively; WS is
regional wages and salaries and supplementary labour income; PIT and PI are regional
(federal and provincial) personal income taxes and regional personal income, respectively;
IT SUB is regional indirect taxes less subsidies; and GRP is gross regional product at
market prices. The lagged change in the resulting regional tax rate is used as a right-hand
variable.
Terms of trade: This is equal to the difference log PNO log PC, where PNO is the regional
net output price and PC the regional consumer price index. PNO is de®ned as the ratio
between nominal and real GRP at factor cost (Conference Board estimates). In the Atlantic
and Prairie provinces, PNO and PC are weighted averages of the net output and consumer
price indices of the component provinces, respectively. The lagged change in the resulting
terms-of-trade variable is used as a right-hand variable.
Youth share of labour force: This is equal to log YOSH, where YOSH is the percentage
of young men and women aged 15 to 24 in the regional labour force. In the estimated
equations, this right-hand variable is projected from regional regressions of log YOSH on
non-linear trends and on one lag each of itself, the unemployment rate, the (log) relative
minimum wage, the UI wage subsidy and union density.
Women share of labour force: This is equal to log WOSH, where WOSH is the percentage of
women 25 and over in the regional labour force. In the estimated equations, this right-hand
variable is projected from regional regressions of log WOSH on non-linear trends and on
 fortin ET AL. 93

one lag each of itself, the unemployment rate, the (log) relative minimum wage, the UI wage
subsidy and union density.

Union density: Percentage of the regional labour force who are union members (from
CALURA reports). In the estimated equations, this right-hand variable is projected from
regional regressions of union density on non-linear trends and on one lag each of itself and
the unemployment rate.

Relative minimum wage: This is equal to the difference log WMIN ± log WMAN, where
WMIN is the regional hourly minimum wage (from Labour Canada reports) and WMAN is
the average hourly manufacturing wage. In the de®nition of the (log) relative minimum wage
that is used as a right-hand variable, log WMAN is projected from regional regressions on
two dummy variables (one for 1967±73 and the other for 1974±91) and on two lags of itself,
the GDP de¯ator, the consumer price index, the unemployment rate, union density and the
UI replacement rate.

UI replacement rate: Percentage of the after-tax wage that is replaced by after-tax UI bene®ts
in the case of strongly-attached workers. The bene®t ceiling is assumed not to be effective
and the replacement rate is adjusted for coverage. The actual variable used is log …1
COV RRS†. Here, COV is the coverage ratio; it is normalized to 1.00 after 1971, and from
there set equal to 0.86 in 1967±68, and 0.89 in 1969±71. RRS is the after-tax replacement rate
for strongly-attached workers; it is equal to 0.600 in 1967±71, 0.675 in 1972±75, 0.667 in
1976±78, and 0.600 again in 1979±91. These measures combine information from the UI Act
and periodical reports on UI statistics (Statistics Canada, Cat. No. 73±001).

UI wage subsidy: The maximum number of weeks of bene®ts per week of work in the
reference period that can be drawn by a person who is minimally quali®ed to receive bene®ts,
adjusted for the relevant wage replacement rate. This is set equal to the expression log (1 ‡
RRW*MAX/MIN). Here, RRW is the replacement rate for weakly-attached workers; it is
equal to 0.500 in 1967±1971, 0.667 in 1972±78 and 0.600 in 1979±91. MIN is the minimum
qualifying period giving access to UI bene®ts. MAX is the maximum duration of bene®ts for
a person who is minimally quali®ed. Before 1972, the ratio MAX/MIN was constant and
equal to 13/15. Between January 1972 and October 1977, MIN was eight weeks and MAX
ranged between 26 and 44 weeks, depending on the excess of the regional unemployment
rate over the national unemployment rate. Beginning in November 1977, MIN and MAX
were both calculated by formulae based on current regional unemployment rates. The
November 1977 formula was eventually modi®ed in February 1990, and again in November
1990. In the de®nition of the UI wage subsidy that is used as a right-hand variable, the ratio
MAX/MIN after 1971 is projected from a set of 20 regressions for the ®ve regions and the
four formulae (January 1972 to October 1977, November 1977 to January 1990, February
1990 to October 1990, and November 1990 to December 1991). In each case, MAX/MIN is
regressed on a region- and formula-speci®c constant and lags of either the regional-national
unemployment gap (for January 1972 to October 1977) or the regional unemployment rate
itself (for the following three subperiods).