## 1canea2019002

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---

### ASSESSING HOUSE PRICES IN CANADA — SBC approach and model
- SBC (static borrowing-capacity) approach: determines how much housing a household can afford given income, prevailing mortgage rate, and leverage requirements.
- Key model relationships:
  - At = α Yt (household allocates portion α of income Yt at origination to service mortgage payment At).
  - Lt = f(itm, Ntm) × α Yt (mortgage loan amount from standard mortgage-contract calculation).
  - PHt = Lt + Dt (attainable housing equals mortgage loan plus down payment).
  - With stable LTV, closed-form: PHt = (1 / LTV) × f(itm, Ntm) × α Yt.
- Baseline parameter assumptions:
  - Median-income households take mortgage loans for 25 years with interest rates fixed for 5-year intervals.
  - Conventional mortgage lending rate for the five-year term from CMHC used.
  - Baseline LTV ratio is 80 percent.
  - Median-income households assumed prospective buyers of median-priced housing.
- Alternative down-payment assumptions: constant share of income or household wealth, or stable LTV (baseline).

### Model implications and mechanisms
- Long-run: nominal house prices grow in line with nominal income (PHṫ = Yṫ) under constant LTV, DSTI, and mortgage rates.
- Permanent decrease in mortgage rates:
  - Permanently increases debt-to-income ratios for new home-owners because Lt / Yt = f(itm, Ntm) × α.
  - Permanently increases price-to-income ratios because PHt / Yt = f(itm, Ntm) × α / LTV.
- Declining mortgage rates increase the down payment as a share of income because lower rates raise the price-to-income ratio when LTV is constant.
- Relevant credit variable for house prices is the flow of newly-issued credit for marginal buyers, not the stock of mortgage credit.
- Large price deviations raise risk of sharp corrections because prices can adjust faster than housing supply or income.

### Data, estimation choices, and empirical results
- Data sources: Real Property Solutions and Teranet house prices; region-specific DSTI αi,t estimated using formula (4) with observed regional house prices, income, and mortgage rates; average for 2004—2006 used to normalize for sample 2000Q1—2018Q4.
- Results presented using both region-specific α and a common α for transparency.
- Overall finding: In most Canadian CMAs, house prices can be explained by households’ borrowing capacity; from 2000 to 2018, house prices in most CMAs grew in line with rising nominal incomes and declining mortgage interest rates.
- Significant valuation gaps (end-2018):
  - Toronto: pricing gap around 50 percent.
  - Vancouver: pricing gap around 50 percent.
  - Hamilton: pricing gap almost 60 percent.
- Historical episode example:
  - Edmonton: at peak in 2007Q3, median house price exceeded attainable level by 60 percent; by 2012Q1 median price became more aligned with fundamentals via moderate price declines, income growth, and sizable declines in mortgage interest rates — a “soft landing.”
- Interest-rate contribution example:
  - In 2017, lower mortgage rates could have added C$100,000 to a median house price of C$400,000 (Edmonton example).
- Recent increases in mortgage rates have exerted downward pressure on house prices.

### Affordability, DSTI findings, and projections
- 2016 Toronto: households with "1.7 times median income" could afford to devote "30 percent" of income to mortgage servicing; at least "20 percent" of such households in Toronto CMA in 2016, but this share shrunk as prices climbed after 2016.
- Using uniform DSTI = "30 percent" of after-tax household income to estimate attainable prices (see Appendix Figure 2).
- DSTI differences across CMAs:
  - Toronto, Vancouver, Victoria: median-income households would need to devote "more than 50 percent" of after-tax income to housing.
  - Other CMAs: share "averaging around 30 percent".
  - Hamilton: "around 30 percent up until 2016", then price surge pushed required DSTI for median household "towards 45 percent".
- Projections and scenarios:
  - If mortgage interest rates continue to increase, they will put house prices under pressure; prices need not decline if income growth compensates for rising interest costs.
  - Staff projections suggest attainable house prices could decline slightly over the next five years (expected income growth supports attainable prices; expected increase in interest rates reduces attainable prices; net effect: slight decline).
- Income growth needed to close pricing gaps over next 5 years (assuming staff’s interest rate projections):
  - Toronto: cumulative annual growth rate (CAGR) needed is "9.3".
  - Vancouver: CAGR needed is "8 percent".
  - Other CMAs with better-aligned prices: income CAGRs "below 3 percent" to close gaps via borrowing capacity alone.
- Risk implication: without very strong income growth in Hamilton, Toronto, and Vancouver there is a risk of further price corrections.
- Supply-side and non-credit factors (speculation, supply constraints) necessary to explain large positive gaps in some CMAs.

### Policy-relevant observations on housing
- SBC framework allows assessment of monetary policy and macroprudential effects: interest rates enter explicitly; DSTI, LTV, and LTI changes can be evaluated for impact on borrowing capacity and house prices.
- Practical implication: policy measures that facilitate greater access to credit would likely increase house prices and household debt.
- Specific caution: policies that increase borrowing capacity (e.g., increasing mortgage amortization periods or subsidizing loans) will likely put upward pressure on prices unless housing supply is exceptionally elastic in the short run.
- Policy priority: measures focused on increasing housing supply needed to durably improve housing affordability over the long term.
- Without additional policy measures, income growth will be decisive for keeping attainable house prices stable or increasing.

---

### INFLATION EXPECTATIONS, FORECAST PERFORMANCE, AND BANK OF CANADA ANALYSIS
- Inflation expectations are remarkably stable and have become more anchored due to the Bank of Canada’s credibility.
- Bank of Canada staff forecast evaluation:
  - Forecast error definition: et+h = πt+h 4 − Et πt+h 4.
  - Sample for forecast-error analysis: 1992Q1–2013Q4.
  - Horizons analyzed: one-year-ahead (h=4), two-years-ahead (h=8), three-years-ahead (h=12).
- Comparative forecast models:
  - Simple Model (Phillips curve, IS curve, Taylor-type rule) estimated with Bayesian methods over 1992–2018.
  - Consensus Economics average forecasts.
  - Inflation Target benchmark.
- Forecast performance (bias and MSE):
  - Staff forecasts less biased than other models for both headline and core inflation.
  - For headline inflation, staff forecasts more accurate up to two years ahead; at three years simple model and inflation target produce more accurate results.
  - For core inflation, simple model and inflation target often yield more accurate forecasts than staff at most horizons (improvements tend not statistically significant).
- Sources of forecast errors:
  - Unforeseen shocks to non-core inflation (commodity and oil prices) are largest contributors to staff forecast errors; largest errors during early 2000s downturn and 2008–2011.
  - Core inflation forecast errors tended to negatively impact accuracy in 2011–2015 (staff tended to overpredict core inflation).
- Shock decomposition highlights:
  - Non-core inflation significant contributor to headline inflation volatility.
  - Negative demand shocks (output gap) have been a drag on inflation, offset by accommodative policy settings.
  - At longer horizons, errors in predicting output gap and policy rate increasingly important.
- Real-time estimation issues:
  - Staff tended to overpredict the output gap and the policy interest rate in real time.
  - Evidence suggests systematic overestimation of the neutral nominal policy rate historically, contributing to projections of policy rates that were too high ex-post.
- Uncertainty around neutral nominal policy rate:
  - Recent estimates suggest neutral nominal policy rate around 3 percent in U.S. and Canada, with significant uncertainty (70 percent confidence bands cited for U.S. estimates).
- Policy messages:
  - Bank of Canada has an outstanding record achieving its inflation objective since 1993.
  - Given uncertainty about the neutral rate and output gap in real time, the Governing Council’s cautious, gradual approach to adjusting policy settings is warranted.
  - Recommended improvements:
    - Improve real-time estimates of the output gap.
    - Improve real-time estimates of the neutral nominal policy rate.
    - Enhance monitoring and forecasting of non-core inflation developments.

### Selected model specification and estimated parameters (posterior means and 90 Percent Confidence intervals)
- IS/Phillips/Taylor model parameters (posterior means [90% CI]):
  - ρ1: 0.04 [0.01 ,0.06]
  - ρ2: 0.71 [0.66 ,0.77]
  - ρ3: 0.39 [0.36 ,0.42]
  - γ: 0.13 [0.10 ,0.15]
  - ω: 0.69 [0.61, 0.75]
  - α: Calibrated 0.85
  - ξ1: 0.74 [0.71 ,0.79]
  - ξ2: 3.05 [2.88 ,3.22]
  - ξ3: 0.23 [0.18 ,0.27]
- Standard deviations (posterior means [90% CI]):
  - εy: 0.59 [0.44 ,0.71]
  - επ c: 0.55 [0.44 ,0.66]
  - επ x: 6.18 [5.22 ,7.56]
  - εR: 0.42 [0.34 ,0.48]
  - εY*: 0.15 [0.13 ,0.19]
  - εr*: 0.02 [0.02 ,0.03]
  - επ*: 0.03 [0.02 ,0.04]

---

### INTERNAL TRADE BARRIERS — METHODOLOGY, ESTIMATES, AND MODELING (Appendix I / III)
- Sample: 12 provinces/territories, the U.S., and the rest of the world; span 1997–2015. Sector classification reclassified to 18 goods and services sectors.
- Trade-cost measure based on micro-founded gravity models; ad valorem equivalents of non-geographic NTBs used in multi-sector model to assess effects on GDP and employment.
- Key aggregate estimates (2015, domestic only, trade-weighted averages):
  - Trade-weighted average total trade barrier for Canada: 55.1 percent.
  - Geography accounts for 57 percent of total trading barriers; non-geographic trade barriers account for 43 percent.
  - Average tariff-equivalent of non-geographic barriers in 2015 (domestic only): 21 percent.
- Distance and border effects:
  - Extra 1,000 km associated with trading barrier increase of around 3-13 percent for agricultural and food products and most manufacturing goods.
  - Bordering a trading partner associated with barrier reduction of 4-30 percent, largest in agriculture and food products, metals, electrical machinery, textiles, and other manufacturing.

### Provincial patterns (2015; trade-weighted averages, domestic only)
- Provinces with lowest trade-weighted average cost of NTBs: Ontario and Quebec.
- Provinces/territories with highest average cost: Prince Edward Island, Newfoundland and Labrador, Nova Scotia and Yukon.
- Selected 2015 values (Trade barrier; Geography; Non-Geography):
  - AB: 50.6; 22.2; 28.3
  - BC: 59.2; 28.0; 31.2
  - MB: 59.1; 17.4; 41.7
  - NB: 61.0; 15.2; 45.8
  - NL: 73.2; 23.2; 50.0
  - NS: 66.9; 21.5; 45.4
  - ON: 53.5; 21.5; 32.0
  - PE: 74.0; 16.2; 57.8
  - QC: 53.3; 13.9; 39.4
  - SK: 52.7; 15.8; 36.9
  - YT: 90.6; 24.3; 66.2
  - Canada (aggregate, domestic only): 55.1; 20.3; 34.8

### Sector patterns (2015; trade-weighted averages, domestic only; Trade barrier; Geography; Non-Geography)
- Agriculture: 37.4; 16.6; 20.8
- Food: 60.5; 33.1; 27.4
- Mining: 15.8; 3.2; 12.6
- Textile: 20.4; 11.1; 9.3
- Petroleum and Chemicals: 12.2; 4.9; 7.3
- Metals: 50.5; 19.3; 31.2
- Machinery and Equipment: 37.0; 14.6; 22.4
- Utilities: 101.5; 10.5; 91.0
- Wholesale and retail trade: 68.2; 29.5; 38.7
- Post and Telecommunications: 72.1; 6.4; 65.7
- Business services: 71.2; 23.4; 47.8
- Education and Health: 100.8; 26.7; 74.1
- All sectors (aggregate, 2015): 55.1; 20.3; 34.8

### Dynamics 1997–2015 (domestic only)
- Domestic trade-weighted average non-geographic barriers:
  - All goods: declined from 23 percent in 1997 to 19 percent in 2015.
  - Services: declined from 51 percent in 1997 to 47 percent in 2015.
- Selected sectoral non-geographic component changes 1997 → 2015:
  - Food: -22.8 percentage points
  - Agriculture: -9.6 percentage points
  - Textile: -8.5 percentage points
  - Post and Telecommunications: +11.5 percentage points
  - Machinery and Equipment: +6.9 percentage points
  - Metals: +4.1 percentage points
- Provincial non-geographic changes 1997 → 2015 (selected):
  - Yukon: -9.4 percentage points
  - Prince Edward Island: -4.9 percentage points
  - Saskatchewan: -3.0 percentage points
  - Quebec: +4.7 percentage points
  - Ontario: +0.4 percentage points
  - Canada aggregate non-geographic change: +0.4 percentage points

### Evidence on regional integration and trade agreements
- Trade agreements associated with lower non-geographic trade barriers (goods only): TILMA (2007), NB-QC (2009), PARE (2010), TCA (2010 ON-QC), NWPTA (2011).
- Signing of these agreements associated with average reduction of trade barriers between 1 and 4 percent based on weighted regressions.
- Example regression coefficients (log(trade) specification, negative indicates higher trade flows):
  - 2007 TILMA: -0.0373*** (0.00366)
  - 2009 NB-QC agreement: -0.0437*** (0.00723)
  - 2010 PARE: -0.0208* (0.0107)
  - 2010 TCA: -0.00876*** (0.00213)
  - 2011 NWPTA: -0.0232*** (0.00285)

---

### GAINS FROM LIBERALIZING INTERNAL TRADE — MODEL RESULTS (Eaton-Kortum multi-sector with migration)
- Step 1 — Importance of observed trade (observed vs no-trade counterfactual):
  - Internal trade increases national real GDP by over 5 percent.
  - External trade increases national real GDP by nearly 11 percent.
  - Trade overall increases national real GDP by nearly 20 percent.
- Provincial Real GDP per capita gains from observed trade (Internal; External; All Trade) — selected:
  - AB: 5.1; 11.4; 20.8
  - BC: 4.4; 13.4; 24.2
  - MB: 8.3; 8.8; 26.0
  - NB: 7.2; 16.4; 36.6
  - NL: 6.9; 13.7; 26.3
  - NS: 9.6; 23.7; 58.8
  - PE: 12.6; 9.0; 33.4
  - ON: 4.4; 9.2; 15.4
  - QC: 5.0; 9.8; 18.0
  - SK: 6.7; 14.1; 26.3
  - YT: 8.6; 19.0; 45.5
  - Canada (national aggregate): 5.1; 10.9; 19.6
- Employment changes from observed trade (Internal; External; All Trade) — selected:
  - MB: 4.7; -2.7; 7.9
  - NS: 6.5; 18.0; 52.6
  - ON: -0.9; -2.2; -5.4
- Key Step 1 findings:
  - Internal trade raises real GDP more among smaller provinces, especially Atlantic provinces.
  - Trade lowers variance of real GDP per worker by 22 percent, promoting greater equality across provinces.
  - Internal trade raises employment substantially in Atlantic provinces and territories.

- Step 2 — Eliminating measured non-geographic internal trade barriers for goods (upper-bound scenario):
  - Removing non-geographic internal trade costs increases trade volumes as share of GDP by roughly 15 percentage points.
  - Internal trade volumes would reach levels similar to international trade volumes.
  - Real GDP per capita increases nationally by 3.8 percent.
- Provincial Real GDP per capita gains from eliminating non-geographic internal trade barriers for goods (Internal; External; All Trade) — selected:
  - AB: 3.2; 6.5; 8.9
  - MB: 7.1; 11.4; 16.1
  - NL: 12.8; 12.0; 21.2
  - PE: 16.2; 9.6; 22.1
  - Canada (national aggregate): 3.8; 6.2; 9.1
- Employment changes in this scenario (Internal; External; All Trade) — selected:
  - NL: 13.3; 8.3; 17.1
  - PE: 18.4; 4.8; 18.4
  - ON: -1.3; -2.0; -2.8
- Migration and employment reallocations:
  - Employment reallocates toward provinces with larger productivity gains (notably Atlantic provinces).
  - Aggregate migration flows from reducing internal non-geographic barriers represent only 0.8 percent of total Canadian employment.
  - Atlantic provinces see significant employment increases (Atlantic aggregate employment increases by 6 percent in simulations).

### Sectoral contributions and policy levers
- Sectoral importance (10 percent reduction experiment): largest GDP gains from liberalizing finance, computers, and business services (FIRE, Computers, R&D, Business Services), wholesale and retail, transport and warehousing.
- Rationale: Sectors supplying intermediate inputs (high forward linkages / Leontief inverse row-sum) generate larger economy-wide gains when liberalized.
- Practical policy implications:
  - Liberalization of business services, transport, and warehousing could be achieved through certification harmonization, labor mobility agreements, or harmonized trucking and transport rules.
  - Some service sectors (education, health, culture and recreation) may be more difficult to liberalize.

### Constitutional, legal, and practical constraints; lessons from other jurisdictions
- Constitutional powers cited: Section 90, Section 91(2), Section 121 of Constitution Act, 1867 — federal powers intersect with provincial powers, limiting unilateral federal action.
- Supreme Court rulings noted: 2011 securities reference; 2018 R. v. Comeau — constraints on coercive federal remedies for internal trade barriers.
- Conclusion: political, cooperative solutions and harmonization (cooperative federalism) are required for meaningful internal trade liberalization in practice.
- International lessons:
  - Australia’s mutual recognition and single consumer protection law success relied on collaborative federalism and active oversight.
  - EU’s Treaty and Mutual Recognition Regulation not directly transferable to Canada due to constitutional differences.

### Robustness and elasticity sensitivity (Appendix IV summary)
- Baseline trade elasticities from Caliendo and Parro (2015); alternative θ in [4, 8] considered.
- Aggregate welfare gains from eliminating internal non-geographic barriers (goods):
  - θ = 8: 3.2 percent
  - Baseline (θ = 6.5): 4.6 percent
  - θ = 4: 7.3 percent
- Regional sensitivity table (Real GDP Per Capita percentage change from eliminating non-geographic internal barriers for goods):
  - AB: θ=4 → 6.0; θ=6.5 → 3.8; θ=8 → 2.8
  - BC: θ=4 → 6.0; θ=6.5 → 3.8; θ=8 → 2.7
  - MB: θ=4 → 13.0; θ=6.5 → 8.3; θ=8 → 5.9
  - NL: θ=4 → 20.7; θ=6.5 → 13.2; θ=8 → 9.0
  - PE: θ=4 → 27.4; θ=6.5 → 17.8; θ=8 → 12.2
  - Canada (aggregate): θ=4 → 7.3; θ=6.5 → 4.6; θ=8 → 3.2

---

### PUBLIC SUPPORT, INSTITUTIONAL EVOLUTION, AND POLICY RECOMMENDATIONS ON INTERNAL TRADE
- Public and business support:
  - 87 percent of Canadian firms (Canadian Federation of Independent Business, 2014) believe premiers should commit to reducing internal trade barriers.
  - Ipsos Public Affairs (2017): 89 percent agree Canadians should be allowed to bring any legally purchased product from one province to another.
  - Nine in ten Canadians say there should be free trade between provinces; 81 percent see reducing barriers as good for consumers; 77 percent good for businesses.
- From AIT to CFTA:
  - AIT (1995) positive list approach; 2015 amendment introduced enforceable dispute resolution and monetary penalties.
  - CFTA signed July 1, 2017: negative list approach, Regulatory Reconciliation and Cooperation Table (RCT), strengthened penalties (maximum $10 million for largest jurisdictions), penalties deposited into internal trade fund (not to complainant).
  - CFTA allows other regional FTAs only if they liberalize beyond CFTA levels.
- Remaining challenges and recent actions:
  - Long list of exceptions includes alcohol, dairy, trucking, corporate registry.
  - Opt-out provisions for reconciliation negotiations; limited progress on labor mobility and professional accreditation.
  - Recent cooperative measures: regulatory changes on occupational health and safety, transport, licensing in agriculture, corporate registry; Safe Food for Canadians Regulations effective January 2019; National Building Code free online April 2019; reconciliation agreements on organic aquaculture labelling and produce inspection; agreements on common safety standards; MRAS system expected by 2020.
- Quantitative headline findings:
  - Average non-geographic trade barrier about 20 percent; ranges from 7 percent (textiles, petroleum and chemicals) to over 27 percent (heavier metals, food products, other manufacturing).
  - Removing non-geographic trade barriers would increase trade volumes to a level similar to international trade volumes.
  - Real GDP per capita would increase by 4 percent nationally if trade in goods fully liberalized.
  - Employment in Atlantic provinces would increase by 6 percent in simulations.
  - Reducing barriers in finance, business and insurance sectors would yield large economy-wide benefits.
- Policy recommendations and implementation priorities:
  - Make reducing internal trade barriers a common priority of federal, provincial and territorial governments; pursue sustained collective effort.
  - Consider “coalition of the willing” to accelerate progress among willing jurisdictions.
  - Identify NTBs clearly and assess progress at regular intervals; set targets to reduce number of exemptions to CFTA.
  - Improve CFTA regulatory reconciliation: adopt “comply or explain” to ensure accountability and speed harmonization.
  - Resource the Internal Trade Secretariat sufficiently (budget and full-time employees) to assess and communicate progress; Secretariat to publish annual reports and assume responsibilities of ad hoc committees.
  - Calibrate penalties for non-compliance to better reflect economic impact.
  - Recognize unilateral provincial action via a “national recognition” regime to accept extra-provincial certifications as deemed-compliant.

*Source: ASSESSING HOUSE PRICES IN CANADA; IMF staff analysis and chapter content (content unit: 1canea2019002).*

### References ____________________________________________________________________________ 15

### ASSESSING HOUSE PRICES IN CANADA

### SBC approach and model
- The static borrowing-capacity (SBC) approach determines how much housing a household can afford given income, prevailing mortgage rate, and leverage requirements.
- Key model relationships:
  - A household allocates a portion α of its income Yt at origination to service mortgage payment, At: At = α Yt.
  - Mortgage loan amount Lt is given by standard mortgage-contract calculation: Lt = f(itm, Ntm) × α Yt.
  - Attainable housing PHt equals mortgage loan plus down payment: PHt = Lt + Dt.
  - With a stable loan-to-value (LTV), the closed-form solution is: PHt = (1 / LTV) × f(itm, Ntm) × α Yt.
- Baseline parameter assumptions used in the analysis:
  - Median-income households take on mortgage loans for 25 years with interest rates fixed for 5-year intervals.
  - Conventional mortgage lending rate for the five-year term from CMHC is used.
  - Baseline loan-to-value (LTV) ratio is 80 percent.
  - Median-income households are assumed to be prospective buyers of median-priced housing.
- Alternative down-payment assumptions noted: constant share of income or household wealth, or stable LTV (baseline).

### Model implications and mechanisms
- Long-run: nominal house prices grow in line with nominal income (PHṫ = Yṫ) under constant LTV, DSTI, and mortgage rates.
- Permanent decrease in mortgage rates:
  - Permanently increases debt-to-income ratios for new home-owners because Lt / Yt = f(itm, Ntm) × α.
  - Permanently increases price-to-income ratios because PHt / Yt = f(itm, Ntm) × α / LTV.
- Declining mortgage rates increase the down payment as a share of income because lower rates raise the price-to-income ratio when LTV is constant, increasing time required to save for down payment.
- The relevant credit variable for house prices is the flow of newly-issued credit for marginal buyers, not the stock of mortgage credit (new vs historical vintages complicate stock interpretation).
- Price deviations from fundamentals adjust via changes in price, changes in borrowing capacity, or both; large deviations raise the risk of sharp price corrections because prices can adjust faster than housing supply or income.

### Data and estimation choices
- Data sources: house prices from Real Property Solutions and Teranet; detailed descriptions in the appendix.
- Region-specific DSTI (αi,t) is estimated by using formula (4) with observed regional house prices, income, and mortgage rates; an average for 2004—2006 is used for the full sample 2000Q1—2018Q4 to normalize and avoid dot-com and financial crisis episodes.
- For transparency, results are presented using both region-specific α and a common α.

### Empirical results and key statistics
- Overall finding: In most Canadian CMAs, house prices can be explained by households’ borrowing capacity; from 2000 to 2018, house prices in most CMAs grew in line with rising nominal incomes and declining mortgage interest rates.
- Significant valuation gaps (2018):
  - Toronto: pricing gap around 50 percent (house prices significantly higher than attainable levels).
  - Vancouver: pricing gap around 50 percent.
  - Hamilton: pricing gap almost 60 percent.
- Examples and historical episodes:
  - Edmonton: at peak in 2007Q3, median house price exceeded attainable level by 60 percent; by 2012Q1 median price became more aligned with fundamentals due to moderate price declines, income growth, and sizable declines in mortgage interest rates—an example of a “soft landing.”
  - Calgary and Edmonton experience suggest large deviations can narrow over time, but adjustment dynamics depend on whether large declines in mortgage rates occur again (which is unlikely according to the analysis).
- Contribution of interest rates to prices:
  - In 2017, when mortgage rates were at their lowest point, lower mortgage rates could have added C$100,000 to the median house price of C$400,000 (Edmonton example).
  - Recent increases in mortgage rates have exerted downward pressure on house prices.

### Policy-relevant observations
- The SBC framework allows straightforward assessment of monetary policy and macroprudential policy effects:
  - Monetary policy: interest rates enter explicitly, so changes in mortgage rates directly affect borrowing capacity and attainable house prices.
  - Macroprudential policy: changes in DSTI, LTV, and LTI ratios can be evaluated for their impact on borrowing capacity and house prices.
- Practical implication: policy measures that facilitate greater access to credit would likely increase house prices and household debt.
- Supply-side and other non-credit factors (e.g., speculation, supply constraints) are necessary to explain large positive gaps in some CMAs (Hamilton, Toronto, Vancouver).

*Source: ASSESSING HOUSE PRICES IN CANADA (June 5, 2019).*

### 16.      Real estate transactions occurring at very elevated prices suggest a rising share of

### 1canea2019002 - 16.      Real estate transactions occurring at very elevated prices suggest a rising share of purchases by households with high income

### Key findings on affordability and borrowing capacity
- In 2016, households in Toronto with "1.7 times median income" could comfortably afford to devote "30 percent" of their income to mortgage debt servicing.
- There were "at least 20 percent" of such households in the Toronto CMA in 2016, but this share has shrunk as house prices continued to climb since 2016, contributing to deteriorating housing affordability.
- Using a uniform DSTI assumption of "30 percent" of after-tax household income, attainable house prices are estimated (see Appendix Figure 2).
- Sizable differences exist in DSTI ratios across CMAs:
  - In Toronto, Vancouver, or Victoria median-income households would need to devote "more than 50 percent" of their after-tax income to housing.
  - The share is considerably lower in other CMAs, "averaging around 30 percent".
  - In Hamilton, the share was "around 30 percent up until 2016", after which a sharp price increase pushed the required DSTI for the median household "towards 45 percent".
- Declines in mortgage rates have been rapidly priced into markets, increasing price-to-income and loan-to-income ratios, larger down payments, and longer saving times — lowering affordability across regions, most markedly in Hamilton, Toronto, and Vancouver.

### Projections, scenarios, and risks
- If mortgage interest rates continue to increase, they will put house prices under pressure; however, house prices need not decline if income growth compensates for rising interest costs.
- Staff Report projections for income growth and interest rates suggest attainable house prices could decline slightly over the next five years:
  - Expected income growth will support attainable prices.
  - Expected increase in interest rates will reduce attainable prices.
  - The net effect suggests a slight decline in attainable prices over the forecast horizon (see Figure 5).
- Income growth required to raise attainable prices enough to close pricing gaps over the next 5 years, assuming staff’s interest rate projections:
  - Toronto: cumulative annual growth rate (CAGR) needed is "9.3".
  - Vancouver: CAGR needed is "8 percent".
  - Other CMAs with better-aligned prices would require income CAGRs "below 3 percent" to close pricing gaps through borrowing capacity alone.
- The results imply that without very strong income growth in Hamilton, Toronto, and Vancouver there is a risk of further price corrections in these markets.
- Historical precedent: In 2006, Calgary and Edmonton saw prices rise sharply above borrowing-capacity estimates; pricing gaps normalized by 2012 via moderate declines in house prices, strong income growth, and a decline in interest rates. Similar normalization is unlikely now because significant declines in interest rates are not expected.

### Quantified valuation gaps and market status
- Since 2000, house price developments in most metropolitan regions can be explained by robust income growth and a decline in mortgage interest rates; prices broadly increased in line with households’ borrowing capacity.
- Since 2015, prices in Hamilton, Toronto, and Vancouver have deviated significantly from fundamentals.
- By the end of 2018:
  - Pricing gaps stood at "around 50 percent" for Toronto and Vancouver.
  - Pricing gaps stood at "almost 60 percent" for Hamilton.

### Policy implications and recommendations
- Nationwide increases in price-to-income ratios have significantly lowered housing affordability; policy measures that increase households’ borrowing capacity are likely to raise house prices and worsen affordability if supply does not respond.
- Specific cautions:
  - Policies that increase borrowing capacity (e.g., increasing mortgage amortization periods or subsidizing loans) will likely put additional upward pressure on prices unless housing supply is exceptionally elastic in the short run.
- Policy priority:
  - Measures focused on increasing housing supply are needed to durably improve housing affordability over the long term.
- Without additional policy measures, income growth will be the decisive factor for keeping attainable house prices stable or increasing in the future.

### Data, methodology, and additional results (selected)
- Main house price data source: Real Property Solutions, LLC. (RPS) database (monthly frequency, available back to 2005M1; extended to 2000M1 using Teranet dynamics).
- Income data approach:
  - Analysis uses pre-tax median family income for aggregates and houses; family-income levels scaled to household income levels using 2016 Census consensus for each CMA.
  - Annual numbers interpolated to quarterly frequency in 2000—2016 and extrapolated to end of 2018 using provincial disposable income dynamics.
- The choice of demand unit (family vs. household) mainly affects income level rather than dynamics; example: in 2016 the median pre-tax income of a "couple family with or without children" was "$89,610", "58 percent higher" than the "all family units" income.
- Figures referenced in the analysis include:
  - Observed aggregate house prices vs. attainable house prices (Figure 2).
  - Implied share of debt-service to after-tax median household income across CMAs (Figure 4).
  - Closing the pricing gap with stronger income growth under staff assumptions (Figure 5).
  - Attainable prices assuming uniform DSTI = "30 % of after-tax household income" (Appendix Figure 2).

*Source: IMF staff analysis as presented in the chapter text and appendix of the provided content.*

### 9.      Inflation expectations are remarkably stable, and they have become more anchored

### 9.      Inflation expectations are remarkably stable, and they have become more anchored

### Stability and anchoring of inflation expectations
- The Bank of Canada’s proven track record in keeping inflation close to target over time has made monetary policy highly credible.  
- Private sector forecasters generally expect inflation to converge rapidly to the inflation target (figure 4, left-hand side).  
- The impact of the current level of inflation on forecasters’ views about future inflation has declined over time; forecasters effectively disregard the current level of inflation when forming their views about future inflation because the Bank of Canada is viewed as highly credible in returning inflation back to target.  
- Figure notes: regressions of annual inflation expectations from Consensus Economics on current levels of annual inflation; both variables expressed as deviations from the inflation target.

### Bank of Canada staff’s inflation forecast errors — definitions and data
- Annual inflation forecast error at horizon h: et+h = πt+h 4 − Et πt+h 4 (equation (1)).  
- Forecast errors analyzed over a sample beginning in 1992Q1 and ending in 2013Q4.  
- Mean forecast error (bias) and mean-squared forecast error (MSE) defined as Et et+h, and Et et+h 2, respectively.  
- Forecast horizons and presentation in tables/figures include one-year-ahead (h=4), two-years-ahead (h=8), and three-years-ahead (h=12).

### Forecast models used for performance comparison
- Simple Model: Phillips curve, IS curve, Taylor-type policy rule; endogenous estimation of potential output, trend real interest rate, and neutral nominal policy rate; estimated using Bayesian methods over a sample ranging from 1992 to 2018.  
- Consensus Economics: average forecast from Consensus Economics for horizon h for annual headline inflation and core inflation.  
- Inflation Target: inflation target taken as the forecast for both annual headline and core inflation at all horizons.

### Forecast performance findings (bias and MSE)
- Bias:
  - Bank of Canada staff forecasts are less biased than forecasts from the other models for both headline and core inflation.
  - Other models tend to over predict inflation, particularly for core inflation.
- MSE:
  - For headline inflation, staff forecasts tend to be more accurate than the other methods up to two years ahead.  
  - At a horizon of three years, the simple model and the inflation target produce more accurate results for headline inflation.  
  - For core inflation, the simple model and the inflation target yield more accurate forecasts than Bank of Canada staff at most horizons (improvements tend not to be statistically significant).

### What went wrong — sources of forecast errors
- Unforeseen shocks to non-core inflation are by far the largest contributors to Bank of Canada staff’s overall inflation forecast errors.  
- Non-core inflation forecast errors account for by far the largest share of staff’s inflation forecast errors; largest forecast errors occurred during episodes with large fluctuations in commodity and oil prices (around the early 2000s downturn, and 2008-2011).  
- Core inflation forecast errors tended to have a negative impact on forecast accuracy in the latter part of the sample (2011 to 2015), reflecting a tendency of staff to overpredict core inflation.

### Shock decomposition insights
- Historical shock decomposition for headline inflation: πt 4 − πt ∗ = ∑i=1 N Ht i (equation (2)), where Ht i is shock contribution to deviation from inflation target.  
- Using the simple model, decompositions 1992–2018 show:
  - Negative demand shocks (the output gap) have been a significant drag on inflation and broadly offset by accommodative monetary policy settings (policy rate shocks).  
  - Non-core inflation is a significant contributor to volatility of headline inflation.  
  - More recently, idiosyncratic shocks to core inflation have also acted to reduce overall inflation.
- Decomposing forecast errors: et+h = ∑i (Ht+h i − Et Ht+h i) (equation (3)). Findings:
  - Idiosyncratic shocks to non-core inflation are key contributors to the largest inflation forecast errors.  
  - At longer forecasting horizons, errors in predicting the output gap and the policy rate play an increasingly important role.  
  - In real time, the simple model suggests staff generally expected the output gap to be stronger and the policy interest rate more contractionary than observed ex-post.

### The output gap and the neutral nominal policy rate in real time
- Real-time estimates of the output gap, the policy rate, and the neutral policy rate are crucial for policy decisions; neutral policy rate estimates obtained from the simple model for real-time analysis.  
- Bank of Canada staff have tended to overpredict the output gap and the policy interest rate (noted especially over 1993-1998 and 2011-2014).  
- Real-time estimates from the simple model suggest staff might have been systematically overestimating the neutral policy rate over history, which could have contributed to projections of the policy rate that turned out too high ex-post — reflecting the large and largely unforeseen fall in global interest rates over the past 30 years.  
- Overstating the neutral policy rate leads to perceptions that policy is more accommodative in real time (policy gap lower) and may result in less monetary tightening than expected.

### Do starting-point errors impact inflation forecast errors?
- Simple regression model for core inflation forecast errors: et+h πc = a + b et y + c et (R−R∗) + εt (equation (4)), where et y is starting-point error in estimating the output gap in real time, and et (R−R∗) is starting-point error in estimating the nominal policy gap in real time.  
- Sample periods analyzed include 1992 to 2013 and 1996 to 2013; horizons include one-, two-, and three-years-ahead.  
- Results:
  - Over the whole sample, real-time errors in estimating the output gap contribute to inflation forecast errors at all three horizons.  
  - Over the more recent sample, errors in estimating the policy-rate gap are more useful at explaining forecast errors at horizons of one- and two-years ahead.  
  - The results show the importance of starting point estimates of the output gap and the policy rate gap when forecasting inflation and determining monetary policy stance in real time.

### Uncertainty around the neutral nominal policy rate
- Estimates of the global neutral interest rate have trended down over the past 30 years.  
- Recent estimates for the U.S. and Canada suggest the neutral nominal policy rate is somewhere around 3 percent in each country, but with significant uncertainty; uncertainty bands for U.S. estimates indicate only a 70 percent level of confidence.  
- Figure 8 compares multiple estimates (Holston, Laubach, and Williams (2017); Johannsen and Mertens (2016); Kiley (2015); Laubach and Williams (2003); Lewis and Vazquez-Grande (2017); Lubik and Matthes (2015); Del Negro, Giannone, Giannoni, and Tambelotti (2017)) and the Bank of Canada range for Canada's Neutral Rate, 2018.

### Summary and policy messages
- The Bank of Canada has an outstanding record in achieving its inflation objective since targeting began in 1993.  
- Headline inflation has averaged close to the target of 2 percent, and inflation expectations have been firmly anchored through business cycle fluctuations and external price shocks.  
- Since 2000, inflation in Canada has averaged close to the rates seen in other advanced economies, and Canadian inflation outcomes have tended to be less volatile.  
- Inflation is also less persistent than in other advanced economies, reflecting very stable inflation expectations and the strong credibility of the Bank of Canada.

*Source: Bank of Canada and staff estimates (content unit: 1canea2019002).*

### 24.      Bank of Canada staff have a good track record at forecasting inflation, although there

### Bank of Canada staff have a good track record at forecasting inflation, although there appears to be some room for improvement along several dimensions.

### Forecast performance: headline and core inflation
- Staff forecasts are less biased than forecasts from the other models for both headline inflation and core inflation.
- On a mean-squared error basis, staff forecasts tend to be more accurate for headline inflation than the other methods examined up to two years ahead.
- At a horizon of three years, more simple forecasting models are at least as accurate (and, depending on the model, sometimes more accurate) than staff forecasts.
- The improvements of simple models at three-year horizons tend not to be statistically significant.
- Core inflation forecasts of the Bank of Canada have tended to be less accurate than forecasts produced by both private sector forecasters and more simple forecasting models.

### Sources and episodes of forecast errors
- Unforeseen shocks to non-core inflation (commodity prices etc.) are by far the largest contributors to Bank of Canada staff’s overall inflation forecast errors.
- The largest forecast errors occurred during episodes with particularly large fluctuations in (non-core) commodity and oil prices, particularly:
  - around the global downturn in the early 2000s, and
  - around the global financial crisis and the early part of the recovery (2008-2011).
- Core inflation forecast errors, while smaller in magnitude than non-core shocks, have tended to have a negative impact on forecast accuracy in the latter part of the sample (2011 to 2015), reflecting a tendency of staff to overpredict core inflation.

### Role of output gap, policy interest rate, and starting-point uncertainty
- Staff’s core inflation errors have generally been quite low, but this masks large and offsetting errors in forecasting the output gap and the policy interest rate.
- At longer forecasting horizons, errors in predicting the output gap and the policy rate play an increasingly important role in explaining inflation forecast errors.
- A simple model suggests staff generally expected:
  - the output gap to be stronger than was observed ex-post, and
  - the policy interest rate to be more contractionary than was observed ex-post.
- Starting-point errors in estimating the neutral policy rate and the output gap in real time appear to contribute to staff’s inflation forecast errors.

### Policy implications and recommendations
- Uncertainty about the neutral nominal policy rate and the output gap in real time suggests that the Governing Council’s cautious, gradual approach to adjusting policy settings is warranted.
- Evidence suggests the Governing Council might have been systematically overestimating the level of the neutral nominal policy rate over the sample examined and likely tended to misperceive the degree of policy space in real time.
  - This could indicate deficiencies in the communication of the policy stance in real time.
- Areas for improvement recommended:
  - Improve real-time estimates of the output gap.
  - Improve real-time estimates of the neutral nominal policy rate.
  - Enhance monitoring and forecasting of non-core inflation developments (commodity and oil price effects).
- The chapter concludes that amid these uncertainties, the Governing Council’s gradual approach to setting monetary policy appears to have served it well.

### Model specification, trends, and estimated parameters (selected)
- Key model equations (as presented):
  - Output Gap (%) yt = 100*(Yt − Yt*)
  - Inflation (quarterly, annualized, %) πt = 400*(Pt − Pt−1)
  - Inflation (year-on-year, %) πt4 = 1/4(πt + πt−1 + πt−2 + πt−3)
  - Neutral Policy Interest Rate (annual, %) Rt* = rt* + πt*
  - IS Curve: yt = ρ1 Et yt+1 + ρ2 yt + ρ3 (rt − rt*) + εt y
  - Phillips Curve (core inflation): πt c = Et πt+1 c + γ yt + εt π c
  - Non-Core Inflation: πt x = ω πt−1 x + (1−ω) πt* + εt π x
  - Overall Inflation: πt = α πt c + (1−α) πt x
  - Monetary Policy: Rt = ξ1 Rt−1 − (1−ξ1)(Rt* + ξ2(πt+4 4 − πt+4 *) + ξ3 yt) + εt R
- Selected posterior means and 90 Percent Confidence intervals (parameters estimated using Metropolis-Hastings, 1,000,000 draws, with a 50 percent burn):
  - ρ1: Posterior Mean 0.04 [0.01 ,0.06]
  - ρ2: Posterior Mean 0.71 [0.66 ,0.77]
  - ρ3: Posterior Mean 0.39 [0.36 ,0.42]
  - γ: Posterior Mean 0.13 [0.10 ,0.15]
  - ω: Posterior Mean 0.69 [0.61, 0.75]
  - α: Calibrated 0.85
  - ξ1: Posterior Mean 0.74 [0.71 ,0.79]
  - ξ2: Posterior Mean 3.05 [2.88 ,3.22]
  - ξ3: Posterior Mean 0.23 [0.18 ,0.27]
- Standard deviations (posterior means and 90 Percent Confidence intervals):
  - εy: 0.59 [0.44 ,0.71]
  - επ c: 0.55 [0.44 ,0.66]
  - επ x: 6.18 [5.22 ,7.56]
  - εR: 0.42 [0.34 ,0.48]
  - εY*: 0.15 [0.13 ,0.19]
  - εr*: 0.02 [0.02 ,0.03]
  - επ*: 0.03 [0.02 ,0.04]

*Source: IMF staff summary of chapter on Bank of Canada forecasting performance (from the provided content unit).*

### Appendix I for the details of the methodology). Ad valorem equivalents of the non-geographic NTBs

### 1canea2019002 - Appendix I for the details of the methodology). Ad valorem equivalents of the non-geographic NTBs

### Methodology and sample
- Sample includes 12 Canadian provinces and territories, the U.S. and the rest of the world; span: 1997 to 2015.
- Sector classification reclassified to 18 new goods and services sectors.
- Data and estimation inputs: output, expenditure and trade data by trading partner; bilateral distances (population-weighted centroids), population, contiguous borders; sector-level elasticities of substitution; dummy variables for regional agreements (TILMA (2007), New Brunswick-Quebec agreement (2009), NWPTA (2011), PARE (2010), Ontario-Quebec agreement (2010)).
- Distance measure: population-weighted centroids for each province, the U.S., and ROW; intraprovincial point-to-point trade flow distances not publicly available for all years/sectors/territories/flows.
- Trade cost measure based on micro-founded gravity models (references in source). Ad valorem equivalents of non-geographic NTBs used in a multi-sector model to assess effects on GDP and employment.
- Notes and data limitations:
  - Data for Northwest Territories and Nunavut merged for consistency before/after 1999.
  - International service flows data available only from 2010 to 2015.
  - Dummy variables for agreements take same value across all sectors; assumed effects occur in the first year after signing.
  - Comparable provincial price data approach was not feasible due to lack of data.

### Estimates of total trade barriers and decomposition
- Trade-weighted average total trade barrier (domestic only) for Canada in 2015: 55.1 percent (Table note: trade-weighted averages excluding international flows).
- Geography accounts for 57 percent of total trading barriers across all regions and trading routes.
- Non-geographic trade barriers account for 43 percent of total trade barriers.
- Average tariff-equivalent of non-geographic barriers in 2015 (domestic only): 21 percent (all averages weighted by total trade flows).
- Distance effects: an extra 1,000 km associated with a trading barrier increase of around 3-13 percent for agricultural and food products and most manufacturing goods; distance effects highest for utilities and retail trade services and lowest for petroleum, chemicals and mining.
- Neighbor (border) effects: bordering a trading partner associated with barrier reduction of 4-30 percent, largest in agriculture and food products, metals, electrical machinery, textiles, and other manufacturing; border effect positive for utilities due to lack of trade data in this sector between bordering regions.

### Provincial patterns (2015; trade-weighted averages, domestic only)
- Provinces with lowest trade-weighted average cost of NTBs in 2015: Ontario and Quebec.
- Provinces/territories with highest average cost in 2015: Prince Edward Island, Newfoundland and Labrador, Nova Scotia and Yukon.
- Non-geographic barriers by province (selected 2015 values from Table 2):
  - AB: Trade barrier 50.6; Geography 22.2; Non-Geography 28.3
  - BC: Trade barrier 59.2; Geography 28.0; Non-Geography 31.2
  - MB: Trade barrier 59.1; Geography 17.4; Non-Geography 41.7
  - NB: Trade barrier 61.0; Geography 15.2; Non-Geography 45.8
  - NL: Trade barrier 73.2; Geography 23.2; Non-Geography 50.0
  - NS: Trade barrier 66.9; Geography 21.5; Non-Geography 45.4
  - ON: Trade barrier 53.5; Geography 21.5; Non-Geography 32.0
  - PE: Trade barrier 74.0; Geography 16.2; Non-Geography 57.8
  - QC: Trade barrier 53.3; Geography 13.9; Non-Geography 39.4
  - SK: Trade barrier 52.7; Geography 15.8; Non-Geography 36.9
  - YT: Trade barrier 90.6; Geography 24.3; Non-Geography 66.2
  - Canada (aggregate, domestic only): Trade barrier 55.1; Geography 20.3; Non-Geography 34.8

### Sector patterns (2015; trade-weighted averages, domestic only)
- Non-geographic barriers vary substantially by sector; 2015 trade barrier and non-geography components (selected):
  - Agriculture: Trade barrier 37.4; Geography 16.6; Non-Geography 20.8
  - Food: Trade barrier 60.5; Geography 33.1; Non-Geography 27.4
  - Mining: Trade barrier 15.8; Geography 3.2; Non-Geography 12.6
  - Textile: Trade barrier 20.4; Geography 11.1; Non-Geography 9.3
  - Petroleum and Chemicals: Trade barrier 12.2; Geography 4.9; Non-Geography 7.3
  - Metals: Trade barrier 50.5; Geography 19.3; Non-Geography 31.2
  - Machinery and Equipment: Trade barrier 37.0; Geography 14.6; Non-Geography 22.4
  - Utilities: Trade barrier 101.5; Geography 10.5; Non-Geography 91.0
  - Wholesale and retail trade: Trade barrier 68.2; Geography 29.5; Non-Geography 38.7
  - Post and Telecommunications: Trade barrier 72.1; Geography 6.4; Non-Geography 65.7
  - Business services: Trade barrier 71.2; Geography 23.4; Non-Geography 47.8
  - Education and Health: Trade barrier 100.8; Geography 26.7; Non-Geography 74.1
  - All sectors (aggregate, 2015): Trade barrier 55.1; Geography 20.3; Non-Geography 34.8

### Dynamics and trends (1997–2015, domestic only)
- Domestic trade-weighted average non-geographic barriers:
  - All goods: declined from 23 percent in 1997 to 19 percent in 2015.
  - Services: declined from 51 percent in 1997 to 47 percent in 2015.
- Sectoral changes 1997 → 2015 (selected changes in non-geographic component):
  - Food: -22.8 percentage points
  - Agriculture: -9.6 percentage points
  - Textile: -8.5 percentage points
  - Post and Telecommunications: +11.5 percentage points
  - Machinery and Equipment: +6.9 percentage points
  - Metals: +4.1 percentage points
- Provincial changes 1997 → 2015 (non-geographic component, selected):
  - Yukon: change -9.4 percentage points
  - Prince Edward Island: change -4.9 percentage points
  - Saskatchewan: change -3.0 percentage points
  - Quebec: change +4.7 percentage points
  - Ontario: change +0.4 percentage points
  - Canada aggregate non-geographic change: +0.4 percentage points

### Regional integration and trade agreements
- Evidence of regional integration in goods trade: heatmap (Table 3) shows declining barriers between major provinces (Alberta, British Columbia, Ontario, Quebec), though declines are smaller than those between other provinces.
- Trade agreements associated with lower non-geographic trade barriers (goods only):
  - TILMA (2007), NB-QC agreement (2009), PARE (2010), TCA (2010 TCA reference for ON-QC), NWPTA (2011) associated with higher trade flows on affected routes.
  - Signing of these agreements associated with average reduction of trade barriers between 1 and 4 percent based on weighted regressions.
- Regression results (goods only): examples of estimated log(trade) coefficients (Table 4; standard errors in parentheses):
  - 2007 TILMA: -0.0373*** (0.00366)
  - 2009 NB-QC agreement: -0.0437*** (0.00723)
  - 2010 PARE: -0.0208* (0.0107)
  - 2010 TCA: -0.00876*** (0.00213)
  - 2011 NWPTA: -0.0232*** (0.00285)
  - Note: negative coefficients indicate association with higher trade flows (regression specification uses log(t) dependent variables and trading-pair/year fixed effects).
- Decomposition of trade growth since agreements (Table 5): for multiple agreements and sectors, growth in interprovincial trade after agreements is largely driven by the decline in measured bilateral trade barriers rather than growth in local production or changes in multilateral resistance.

### Gains from liberalizing internal trade (modeling framework)
- Model: trade and migration model with full intersectoral input-output linkages; Eaton-Kortum trade framework with worker mobility across provinces (but not across countries); builds on Tombe and Winter (2018), and Caliendo and Parro (2015); details in Appendix III.
- Mechanisms captured:
  - Lower trade costs reallocate spending toward cheapest producers, narrow domestic product range, and raise aggregate productivity through specialization consistent with comparative advantage.
  - Worker migration across provinces responds to real wage differentials.
- Interpretation of results:
  - Results are comparative static comparisons between two equilibria (long-run potential gains).
  - Analysis abstracts from adjustment costs and timing; short-run adjustment costs and transition durations are not quantified.

*Source: STATCAN; and staff calculations.*

### 18.      In the model, a province’s real GDP per capita increases with interprovincial trade.

### 18. In the model, a province’s real GDP per capita increases with interprovincial trade

### Model structure and calibration
- Change in province n’s per capita GDP, 푦̂푛, is given by: 푦̂푛 = ∏(휋̂푛푛푗)^(−푔푗/휃푗) 퐽푗=1.  
  - 휋̂푛푛퐽 is the change in how much spending is allocated to local producers.  
  - 푔푗 is a measure of sector 푗’s “importance” in the supply chain.  
  - 휃푗 is the elasticity of trade.  
- National overall real GDP change, 푌̂, depends on provincial per capita changes and employment allocation changes: 푌̂ = ∑휔푛푦̂푛퐿̂푛푁푛=1, where 휔푛 is a weight of province n in Canada’s real per capita GDP.
- Calibration details:
  - Initial equilibrium exactly matches observed trade flows.
  - Production and consumption parameters from Canada’s supply-and-use tables for 2015.
  - Trade elasticities: goods sectors from Caliendo and Parro (2015); service sectors elasticity set to 5 (following Costinot and Rodriguez-Clare (2014)).
  - Income-elasticity of migration set to 1.5 (as in Tombe and Winter (2018)).

### Step 1 — Importance of observed trade (relative to autarky)
- National aggregate results (observed trade relative to no-trade counterfactual):
  - Internal trade increases national real GDP by over 5 percent.
  - External trade increases national real GDP by nearly 11 percent.
  - Trade overall increases national real GDP by nearly 20 percent.
- Provincial real GDP per capita gains from observed trade (Real GDP Per Capita, percentage change; columns: Internal, External, All Trade):
  - AB: 5.1, 11.4, 20.8
  - BC: 4.4, 13.4, 24.2
  - MB: 8.3, 8.8, 26.0
  - NB: 7.2, 16.4, 36.6
  - NL: 6.9, 13.7, 26.3
  - NS: 9.6, 23.7, 58.8
  - NT & NU: 8.7, 10.5, 28.8
  - ON: 4.4, 9.2, 15.4
  - PE: 12.6, 9.0, 33.4
  - QC: 5.0, 9.8, 18.0
  - SK: 6.7, 14.1, 26.3
  - YT: 8.6, 19.0, 45.5
  - Canada (national aggregate): 5.1, 10.9, 19.6
- Employment changes from observed trade (Employment, percentage change; columns: Internal, External, All Trade):
  - AB: 0.1, 0.9, 1.3
  - BC: -1.0, 3.6, 5.5
  - MB: 4.7, -2.7, 7.9
  - NB: 3.1, 7.7, 21.8
  - NL: 2.5, 4.0, 8.2
  - NS: 6.5, 18.0, 52.6
  - NT & NU: 5.2, -0.3, 11.4
  - ON: -0.9, -2.2, -5.4
  - PE: 10.8, -2.4, 17.4
  - QC: -0.2, -1.4, -2.3
  - SK: 2.3, 4.5, 8.2
  - YT: 5.0, 11.4, 33.8
  - Canada (national aggregate): - - -
- Key findings from Step 1:
  - Internal trade increases real GDP more among smaller provinces, especially Atlantic provinces.
  - Combined provincial gains range from 15.4 percent (Ontario) to 58.8 percent (Nova Scotia).
  - Trade lowers the variance of real GDP per worker by 22 percent, promoting greater equality across provinces.
  - Internal trade raises employment substantially in Atlantic provinces and the territories (e.g., Prince Edward Island employment nearly 11 percent higher relative to no internal trade).
  - External trade reallocates employment: western provinces and most Atlantic provinces see employment gains; some provinces see declines. Overall, trade sustains higher employment outside Ontario and Quebec.
  - Employment shifts primarily driven by changes in real incomes and migration responses.

### Step 2 — Impact of eliminating measured non-geographic internal trade barriers for goods
- Scenario: complete liberalization of internal trade for the 9 goods sectors by removing measured non-geographic internal trade costs (an upper-bound welfare scenario).
- Aggregate effects:
  - Removing non-geographic internal trade costs increases trade volumes as a share of GDP by roughly 15 percentage points.
  - Internal trade volumes would reach levels similar to international trade volumes (a situation not seen in Canada since the early 1980s).
  - Real GDP per capita increases nationally by 3.8 percent; combined (internal + external + all trade) effects presented in Table 7.
- Provincial Real GDP per capita gains from eliminating non-geographic internal trade barriers for goods (Real GDP Per Capita, percentage change; columns: Internal, External, All Trade):
  - AB: 3.2, 6.5, 8.9
  - BC: 2.8, 5.7, 7.9
  - MB: 7.1, 11.4, 16.1
  - NB: 6.0, 5.6, 10.0
  - NL: 12.8, 12.0, 21.2
  - NS: 4.8, 19.8, 22.0
  - NT & NU: 7.5, 7.6, 13.3
  - ON: 2.9, 4.8, 7.0
  - PE: 16.2, 9.6, 22.1
  - QC: 4.6, 6.1, 9.6
  - SK: 5.1, 5.7, 9.6
  - YT: 6.9, 4.2, 9.8
  - Canada (national aggregate): 3.8, 6.2, 9.1
- Employment changes from eliminating non-geographic internal trade barriers for goods (Employment, percentage change; columns: Internal, External, All Trade):
  - AB: -0.9, 0.4, -0.2
  - BC: -1.5, -0.7, -1.6
  - MB: 4.8, 7.4, 9.8
  - NB: 3.1, -0.8, 1.2
  - NL: 13.3, 8.3, 17.1
  - NS: 1.4, 19.8, 18.2
  - NT & NU: 5.3, 2.0, 5.9
  - ON: -1.3, -2.0, -2.8
  - PE: 18.4, 4.8, 18.4
  - QC: 1.0, -0.2, 0.7
  - SK: 1.9, -0.7, 0.7
  - YT: 4.5, -2.8, 1.0
  - Canada (national aggregate): - - -
- Migration and employment reallocations:
  - Employment reallocates toward provinces with larger productivity gains (notably Atlantic provinces).
  - Aggregate migration flows from reducing internal non-geographic barriers represent only 0.8 percent of total Canadian employment.
  - Atlantic provinces see significant employment increases overall (Atlantic aggregate employment increases by 6 percent in simulations).

### Sector-specific contributions to gains
- Method: reduce measured internal trade costs in each sector, one at a time, by 10 percent to compare sectoral importance.
- Largest GDP gains come from liberalizing:
  - finance, computers, and business services (FIRE, Computers, R&D, Business Services)
  - wholesale and retail activities
  - transport and warehousing
- Rationale:
  - Sectors that are important suppliers of intermediate inputs (high total forward linkage / row-sum of the Leontief Inverse Matrix) generate larger economy-wide gains when liberalized.
  - Lower trade costs in these key input-supplying sectors cascade through the economy and boost productivity in all sectors that use these inputs.
- Practical policy implications:
  - Liberalization of business services, transport, and warehousing could be achieved through certification harmonization, labor mobility agreements, or harmonized trucking and transport rules.
  - Some service sectors (education, health, culture and recreation) may be more difficult to liberalize.

### Constitutional powers, practical constraints, and policy approach
- Constitutional powers:
  - Section 90 of the Constitution Act, 1867: federal authorities can reserve or disallow new provincial legislation that inhibits internal trade (power usable within the first year of provincial law enactment; not specific to trade).
  - Section 91(2): federal government control over “trade and commerce”.
  - Section 121: goods should be admitted freely across provinces.
- Practical and legal constraints:
  - Federal powers intersect with provincial powers (e.g., Section 92(13) over “property and civil rights”), creating legal limits to unilateral federal action.
  - Supreme Court rulings:
    - 2011 securities reference: proposed 2010 Canadian Securities Act invalid under federal trade and commerce powers (federal intrusion into provincial powers).
    - 2018 R. v. Comeau: New Brunswick was within its rights to impose fines on transportation of alcoholic beverages into the province; Section 121 interpreted in historical context and constrained by federalism principles.
- Policy conclusion:
  - A political, cooperative solution is the only viable path to meaningful internal trade liberalization in practice.
  - Harmonization and cooperative federalism are required to address regulatory differences that create most internal trade barriers.
  - Recent cooperative moves: renegotiation of the AIT (2014-2017) resulting in the CFTA, messages from the 2018 Council of the Federation meeting, and the December 2018 First Ministers’ Meeting indicate willingness to act.

### Lessons from other jurisdictions
- Australia:
  - Adopted mutual recognition in 1993 to remove regulatory barriers; led to greater competition, lower prices, and more choices (Productivity Commission, 2009).
  - Single consumer protection law in 2010 replaced state/territory laws.
  - Success relied on collaborative federalism, Mutual Recognition Accord of 1992, and an active Productivity Commission.
  - Australian courts have applied constitutional provisions (similar to Canada’s Section 121) to invalidate laws creating internal trade barriers.
- European Union:
  - Treaty of Rome prohibits measures “capable of hindering, directly or indirectly, actually or potentially, intra-Community trade”.
  - Directives and the Mutual Recognition Regulation (Regulation (EC) No 764/2008) require harmonization and facilitate free movement of goods and services.
  - European Commission provides oversight on proposed legislative and regulatory changes.
- Transferability to Canada:
  - Australia’s and the EU’s approaches cannot be directly translated to Canada due to constitutional differences and Canadian courts’ narrower interpretations of Section 121 (historical context and respect for provincial regulatory diversity).
  - Coercive approaches like the EU’s may be difficult to envisage in Canada; cooperative federalism is the more practical route.

*Source: Staff calculations and analysis from the provided chapter content.*

### 34.      There is overwhelming public support for free internal trade. The surveys of the

### 34.      There is overwhelming public support for free internal trade.

### Public support and survey evidence
- 87 percent of Canadian firms (Canadian Federation of Independent Business, 2014) believe that provincial and territorial premiers should commit to reducing internal trade barriers.
- Nine in ten small businesses (including the Retail Council of Canada, the Canadian Vintners Association, the Canadian Federation of Agriculture, the Business Council of Canada, and the Canadian Welding Bureau) think that all firms should have open access to all markets in Canada.
- More than half of firms believe that provincial and territorial governments should not protect local businesses from competition in other provinces and territories.
- Ipsos Public Affairs (2017) found 89 percent of respondents agree that Canadians should be allowed to bring any legally purchased product from one province to another.
- Nine in ten Canadians say there should be free trade between the provinces “because we are one country.”
- 81 percent see reducing trade barriers between provinces as good for consumers.
- 77 percent see reducing trade barriers between provinces as good for Canadian businesses.

### From AIT to CFTA — institutional evolution and features
- The AIT (Agreement on Internal Trade) came into force in 1995; it adopted a positive list approach focused on removing trade barriers in eleven sectors and initially lacked an effective dispute resolution mechanism.
- In 2015, the AIT was amended to include an enforceable dispute resolution mechanism with monetary penalties for non-compliance; public procurement transparency improved and labor mobility for regulated occupations was enhanced.
- The Canadian Free Trade Agreement (CFTA) was signed by the government of Canada, the ten provinces and three territories on July 1, 2017.
- The CFTA adopts a negative list approach where rules apply automatically to almost all areas of economic activity, with explicitly identified exceptions; the number of exemptions is large and itemized in well over 135 pages.
- The CFTA enhances government procurement rules, introduces a Regulatory Reconciliation and Cooperation Table (RCT) to eliminate duplicate, overlapping and inconsistent regulations, and carries forward the 2015 AIT dispute settlement mechanism with strengthened penalties for non-compliance.
- Penalties for non-compliance were raised for the largest jurisdictions to a maximum of $10 million; fines collected would be deposited into an internal trade fund and not as compensation to the complainant.
- The CFTA is fully harmonized with international agreements to ensure a level playing field for domestic and foreign firms.
- The CFTA allows other regional free trade agreements only if they liberalize trade, investment, labor mobility beyond the level achieved by the CFTA.

### Remaining challenges and recent federal/provincial actions
- The long list of exceptions includes areas most affected by internal trade barriers: alcohol, dairy and other farm products, trucking regulations, corporate registry.
- Despite the RCT, governments can opt out of negotiations if they do not have an existing measure to reconcile or determine reconciliation is undesirable; the opt out must be transparently listed on the CFTA’s website.
- Progress on labor mobility and professional accreditation remains limited.
- The Internal Trade Secretariat is insufficiently resourced to study and prepare regular progress reports.
- Recent cooperative actions and regulatory changes:
  - Agreement to reduce regulatory restrictions related to occupational health and safety, transport regulation, licensing in agriculture, and corporate registry.
  - Agreement to address personal use exemption limits for alcohol when crossing provincial/territorial boundaries; some jurisdictions may eliminate limits entirely (current exceptions: Manitoba, Alberta, Prince Edward Island, Nova Scotia and Saskatchewan).
  - Safe Food for Canadians Regulations came into effect in January 2019.
  - The National Building Code was made available for free online in April 2019.
  - Two reconciliation agreements reached: organic labelling for aquaculture products and inspection requirements for produce.
  - Provinces, territories and the federal government agreed to adopt and recognize common standards for first aid kits, head protection, eye and face protection, hearing protection, foot protection, and personal floatation devices and life jackets.
  - Provinces, territories and the federal government agreed in principle to allow the use of wide-base single tires at weight parity with conventional dual tires on all major trade routes in Canada by the end of 2019.
  - A new multi-jurisdictional registry access system (MRAS) is being developed to enable streamlined registration and mutual recognition for multi-jurisdictional businesses; the system is expected to be in operation by 2020.

### Key quantitative findings on trade barriers and economy-wide effects
- The average non-geographical trade barrier is about 20 percent.
- Non-geographic barriers range from 7 percent for textiles, petroleum and chemicals to over 27 percent for heavier metals, food products and other manufacturing goods.
- Alberta, British Columbia, and Ontario have the lowest non-geographic barriers.
- Manitoba, Prince Edward Island, Nova Scotia, Yukon, and Newfoundland and Labrador have the highest non-geographic barriers.
- Removing non-geographic trade barriers would increase trade volumes to a level similar to international trade volumes.
- Real GDP per capita would increase by 4 percent nationally if trade in goods was fully liberalized.
- Employment effects: workers would migrate toward regions with above-average productivity gains; employment in Atlantic provinces would increase by 6 percent.
- Sectoral priorities: reducing barriers in the finance, business and insurance sectors would most benefit the economy due to high interconnectivity; this reinforces the case for unified securities regulations across provinces and enhanced labor mobility.

### Policy recommendations and implementation priorities
- Make reducing internal trade barriers a common priority of federal, provincial and territorial governments; a sustained and concerted collective effort is necessary.
- Consider a “coalition of the willing” as a way to accelerate progress among jurisdictions ready to move faster.
- NTBs (non-tariff barriers) should be clearly identified and progress towards removing them should be assessed at regular intervals.
- Targets for a reduction in the number of exemptions to the CFTA should be explicitly set out in future negotiations.
- Improve the CFTA regulatory reconciliation process:
  - The current process is administratively burdensome, negotiations are protracted, and provinces can opt out.
  - Adopt a “comply or explain” approach to ensure better accountability and accelerate harmonization of regulations.
- Resource the Secretariat sufficiently (with budget and full-time employees) to assess and communicate progress on trade liberalization, including publishing an annual report on goals set and progress in achieving them; the Secretariat should assume responsibilities of ad hoc committees and working groups to initiate, develop, and monitor policy reforms.
- Calibrate penalties for non-compliance to better distinguish large barriers from small; current penalties, though raised in 2017, still do not fully reflect the magnitude of the economic impact.
- Recognize unilateral provincial action through a “national recognition” regime where a province would consider a certification from another province as deemed-compliant with its own; recognizing extra-provincial certifications, standards, and registrations can benefit a single province even if recognition is not reciprocated.

*Source: IMF — Canada country report chapter content.*

### Appendix III. Estimating the Impact of Internal Trade Barriers:

### Appendix III. Estimating the Impact of Internal Trade Barriers: the Model

### Model structure and objectives
- Builds on Tombe and Winter (2018): a multi-sector Eaton and Kortum (2002) model with intersectoral linkages and interprovincial migration.
- Solved in the “Exact Hat Algebra” form following Caliendo and Parro (2015) to simulate counterfactual responses of GDP, employment, wages, prices to eliminating policy-relevant (non-geographic) trade costs starting from an initial equilibrium that exactly matches observed interprovincial and international trade.
- Environment mapped to multi-region input-output data with N regions, each with L_n individuals, J sectors, and sector expenditure shares β_j such that individual utility U_n = ∏_{j=1}^J (C_{n j})^{β_j}.
- Firms produce heterogeneous varieties with productivity φ_{n j}(ν) and require labor l_{n j}(ν) and intermediate inputs q_{n j k}(ν) with production function:
  y_{n j}(ν) = φ_{n j}(ν) l(ν)^{ϕ_j} [∏_{k=1}^J q_{n j k}(ν)^{σ_{j k}}].

### Key equations, calibration, and price formation
- Trade involves iceberg costs τ_{n i j} ≥ 1. Production cost measure:
  π_{n i j} ∝ (τ_{n i j} c_{i j} P_{n j} / A_{i j})^{-θ_j}, where θ_j is the trade-cost elasticity, A_{i j} is fundamental productivity, P_{n j} is average price in importer n, and c_{i j} is input bundle cost in i for sector j.
- Input-bundle cost:
  c_{i j} ∝ w_i^{ϕ_j} [∏_{k=1}^J (P_{i k})^{σ_{j k}}].
- Average prices:
  P_{n j} ∝ [∑_{i=1}^N (τ_{n i j} c_{i j} / A_{i j})^{-θ_j}]^{-1/θ_j}.
- Calibration: input-output parameters σ_{j k} and ϕ_j calibrated to match Statistics Canada data table 36-10-0001-01 aggregated to 18 broad sectors for 2015.

### Real wages, Leontief linkages, and transmission channels
- Real wages relate to trade shares, productivity, and input prices:
  w_n / P_{n j} ∝ A_{n j} (π_{n n j})^{-1/θ_j} [∏_{k=1}^J (w_n / P_{n k})^{σ_{j k}}].
- Log-linear mapping using Direct Requirements Matrix A and Leontief inverse:
  W = Π^T (I − A)^{-1},
  where W is N×J matrix of log real wage changes, Π is N×J matrix of changes in home-shares −log(π̂_{n n j})/θ_j.
- Two channels for trade-cost effects on real wages:
  - Reallocation to more productive external producers reduces domestic home-share (π̂_{n n j} < 1), raising average labor productivity in sector j and region n.
  - Productivity gains cascade through intersectoral linkages captured by (I − A)^{-1}.

### Solving counterfactuals: trade shares, prices, production costs, and wages
- Changes in trade shares:
  π̂_{n i j} ∝ (τ̂_{n i j} ĉ_{i j} / P̂_{n j})^{-θ_j}, with τ̂ exogenous (estimated costs).
- Equilibrium price and production-cost changes:
  P̂_{n j} ∝ [∑_{i=1}^N π_{n i j} (τ̂_{n i j} ĉ_{i j})^{-θ_j}]^{-1/θ_j},
  ĉ_{i j} ∝ ŵ_i^{ϕ_j} [∏_{k=1}^J (P̂_{i k})^{σ_{j k}}].
- Wages solved endogenously by iterating: guess wage changes → compute production costs, prices, trade shares → infer sector sales and total payments to labor → update wages given counterfactual employment distribution.

### Migration, employment, and aggregation to GDP
- Workers can reallocate across sectors within a region at zero cost (wages equalize across sectors) but face migration costs across regions; worker location preferences are heterogeneous.
- Aggregate price index change in region n:
  P̂_n = ∏_{j=1}^J (P̂_{n j})^{β_j}.
- Employment changes from real wage changes:
  log(L̂_n) ∝ κ · log(ŵ_n / P̂_n), where κ is the income-elasticity of migration determined by preference heterogeneity; proportionality constant ensures employment shares sum to one. Migration restricted to within-Canada moves (international migration not modeled).
- Province aggregate real GDP Y_n equals aggregate real wages across sectors; welfare aggregation:
  Y = Π^T (I − A)^{-1} β.
- National aggregate real GDP change:
  Aggregate Real GDP Change = ∑_n ω_n L̂_n Û_{n n}, where ω_n is province n’s initial share of national nominal GDP.

### Trade imbalances and sensitivity note
- Observed trade imbalances are not incorporated. Quantitative results are not meaningfully dependent on allowing trade imbalances.
- Example: aggregate gains from internal trade are 5.35% in a model where exogenous trade imbalances match observed trade surplus to GDP ratios in the initial equilibrium; this compares to the 5.18% gains reported in the chapter.

### Robustness to alternative trade-cost elasticities (Appendix IV summary)
- Baseline uses elasticities from Caliendo and Parro (2015). Alternative estimates exist; Bemrose et al. (2017) estimate aggregate θ = 6.4.
- Lower θ implies larger gains from trade liberalization in this model class.
- Aggregate results reported for θ in [4, 8].
- Aggregate welfare gains from eliminating internal non-geographic barriers:
  - θ = 8: 3.2 percent (high-end elasticity)
  - Baseline (θ = 6.5): 4.6 percent reported in table summary for Canada
  - θ = 4: 7.3 percent

### Regional results from Table 1 — Gains from Eliminating Non-Geographic Internal Barriers for Goods, 2015
Real GDP Per Capita (percentage change)
- AB: θ=4 → 6.0; θ=6.5 → 3.8; θ=8 → 2.8
- BC: θ=4 → 6.0; θ=6.5 → 3.8; θ=8 → 2.7
- MB: θ=4 → 13.0; θ=6.5 → 8.3; θ=8 → 5.9
- NB: θ=4 → 10.9; θ=6.5 → 6.9; θ=8 → 4.9
- NL: θ=4 → 20.7; θ=6.5 → 13.2; θ=8 → 9.0
- NS: θ=4 → 10.8; θ=6.5 → 6.8; θ=8 → 4.7
- NT & NU: θ=4 → 12.7; θ=6.5 → 8.1; θ=8 → 5.6
- ON: θ=4 → 5.9; θ=6.5 → 3.6; θ=8 → 2.6
- PE: θ=4 → 27.4; θ=6.5 → 17.8; θ=8 → 12.2
- QC: θ=4 → 8.9; θ=6.5 → 5.6; θ=8 → 3.9
- SK: θ=4 → 9.8; θ=6.5 → 6.2; θ=8 → 4.3
- YT: θ=4 → 13.0; θ=6.5 → 8.2; θ=8 → 5.8
- Canada (aggregate): θ=4 → 7.3; θ=6.5 → 4.6; θ=8 → 3.2

Employment (percentage change)
- AB: θ=4 → -2.1; θ=6.5 → -1.3; θ=8 → -0.8
- BC: θ=4 → -2.1; θ=6.5 → -1.4; θ=8 → -0.9
- MB: θ=4 → 7.7; θ=6.5 → 5.3; θ=8 → 3.8
- NB: θ=4 → 4.7; θ=6.5 → 3.2; θ=8 → 2.3
- NL: θ=4 → 19.0; θ=6.5 → 12.4; θ=8 → 8.3
- NS: θ=4 → 4.6; θ=6.5 → 3.1; θ=8 → 1.9
- NT & NU: θ=4 → 7.4; θ=6.5 → 4.9; θ=8 → 3.3
- ON: θ=4 → -2.3; θ=6.5 → -1.6; θ=8 → -1.1
- PE: θ=4 → 29.0; θ=6.5 → 19.3; θ=8 → 13.2
- QC: θ=4 → 1.9; θ=6.5 → 1.3; θ=8 → 0.8
- SK: θ=4 → 3.2; θ=6.5 → 2.1; θ=8 → 1.4
- YT: θ=4 → 7.8; θ=6.5 → 5.1; θ=8 → 3.6
- Canada: employment changes not reported in the table summary for aggregate.

*Source: Appendix III. Estimating the Impact of Internal Trade Barriers (1canea2019002).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1canea2019002.pdf_