Labor Market Adjustment in Canada and the United States

Since the early 1980s, the aggregate unemployment rate in Canada has been persistently higher than that in the United States. However, existing research has failed to identify conclusively the proximate determinant for the persistent unemployment gap between these two countries. This paper takes a different approach from previous literature by providing a quantitative assessment of the relative importance of various labor market adjustment mechanisms in Canada and the United States. The paper also directly examines the effects of the unemployment insurance (UI) system on labor market adjustment. This analysis is designed to shed some light on why similar shocks in the two countries could potentially result in dissimilar labor market outcomes, both in the short run and in the long run. In addition, the relative importance of different labor market adjustment mechanisms could have implications for designing effective policies to address the unemployment problem in Canada. The results indicate some similarities but also a few interesting differences between the two countries in the relative importance of different channels of labor market adjustment in response to employment growth shocks. The responses of unemployment rates are quite similar in the two countries, although there are some differences in the long-run responses of employment levels and the participation rate. The real wage response to an employment growth shock is more muted in Canada than in the United States, suggesting a lower degree of real wage flexibility in Canada. However, it does not appear that differences in real wage flexibility can account for much of the discrepancy in unemployment persistence across the two countries in recent years. Although the overall generosity of the UI system is found to have increased aggregate unemployment persistence in Canada, this paper concludes that the endogenous component of U has not had a significant effect on unemployment persistence.