## _wp04138 - References

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### I. Introduction — purpose and questions
- Paper analyzes impact of major Canada-U.S. trade agreements on business cycle dynamics and productivity.
- Central questions:
  - What has been the impact of the major trade agreements on trade and financial flows between the two countries?
  - What has been the effect of increased economic linkages on the comovement of business cycles in Canada and the United States?
  - How has economic integration affected the labor productivity gap between the two economies?

### Key milestones and institutional developments
- 1965 Canada-U.S. auto pact:
  - Eliminated tariffs on automotive products (prior tariffs roughly "7½ percent" in Canada and "17½ percent" in the United States).
  - Led to significant growth and integration of the Canadian auto industry.
- 1989 Canada-U.S. Free Trade Agreement (CUSFTA):
  - Introduced free trade in almost all sectors.
  - Average Canadian tariff on manufacturing imports from the United States fell from "3 percent" in 1989 to almost zero in 2001.
  - Average U.S. tariff on imports from Canada fell from around "4.5 percent" to "0.5 percent" during the same period.
  - Reduced nontariff barriers and provided rules covering services, investment, and dispute settlement mechanisms.
- 1994 North American Free Trade Agreement (NAFTA):
  - Broadened CUSFTA by including Mexico; NAFTA entered into force on "January 1, 1994."
  - In 2002, total GDP of NAFTA members was more than "25 percent" larger than that of the European Union.
  - Exports (imports) of the European Union constituted roughly "38 (35) percent" of world exports (imports) while exports (imports) of NAFTA accounted for about "18 (25) percent".
  - Eliminated the majority of tariffs in its first ten years and phased out most remaining tariffs by 2008.
  - Expanded coverage to investment flows, financial services, government purchases, and intellectual property rights.
  - Included side agreements: North American Agreement on Labor Cooperation and North American Agreement on Environmental Cooperation.
  - Preserved some sectoral protections (e.g., separate agricultural market access requirements) and comprehensive rules of origin; included safeguard clauses for import surges.

### III. Dynamics of trade and financial flows — stylized facts
- Growth of trade flows:
  - Canada’s merchandise trade to the United States more than doubled in U.S. dollar terms over the period 1988–2002.
  - Trade with the United States, on average, grew more than two times faster than GDP after the inception of CUSFTA.
  - Share of exports to the United States rose from around "30 percent" of GDP to as high as "55 percent" of GDP.
  - By 2002, roughly "90 percent" of Canadian merchandise exports were directed to the United States, a "17 percentage point" increase from 1988.
  - Share of Canadian imports from the United States remained roughly unchanged at around "65 percent" during the same period.
- Changes in product mix:
  - Transportation equipment, machinery and electronics continued to be significant but decreased in importance during 1989–92.
  - Share of exports associated with primary sectors (metals and minerals; wood and pulp) declined somewhat.
  - Sharp increases in apparel and textiles and special transactions; significant increase in share of exports from agriculture and oil sectors directed to the United States.
- National and regional effects within Canada:
  - Contribution of net exports to GDP growth jumped from about zero during 1973–88 to about "0.75 percentage points" after CUSFTA.
  - Regions previously weakly tied to U.S. market (British Columbia, the Prairies, the Atlantic region) saw sharp jumps in share of exports directed to the United States, narrowing gaps with Ontario and Quebec.
  - Average share of international trade in provincial GDP rose from "42 percent" in 1991 to "75 percent" in 2000.
  - Ontario’s exports to the United States rose from "25 percent" of its GDP in 1989 to almost "50 percent" in 2001.
- Regional gravity-model findings (selected results cited):
  - NAFTA resulted in large increase in trade volume between Central Canada (Ontario and Quebec) and the United States during 1993–97.
  - NAFTA led to a decrease in trade between Eastern Canada (New Brunswick, Newfoundland, Nova Scotia, Prince Edward Island).
  - Impact on trade flows from Western Canada (Alberta, British Columbia, Manitoba, Saskatchewan) to the United States was relatively minor.
  - Regional trade flows with the United States rose by "6.7 percent per year" for Ontario (Gu and Sawchuk (2001) result cited).

### IV. Business-cycle comovement and driving factors (summary of findings)
- Increased trade and financial linkages led to significant changes in dynamics of Canada’s business cycles.
- Canada-U.S. business cycles have become more synchronized; rapid growth of intra-industry trade contributed to greater cross-country correlations of investment and imports.
- Dynamic latent factor model results:
  - The common factor has played an increased role in explaining business cycles in Canada and the United States since the early 1980s.
  - Country-specific and idiosyncratic factors remain important in Canada.
- Factor and variance decomposition highlights:
  - Over 1960Q1–2002Q4, common factor explains about 10 percent of Canada’s output volatility; country and idiosyncratic factors explain bulk of volatility.
  - Comparing 1960Q1–1981Q2 vs 1981Q3–2002Q4:
    - Share of Canada’s output variance explained by common factor roughly tripled in the later period.
    - Share of investment due to common factor rose fourfold; consumption share due to common factor increased from less than 5 percent to roughly 40 percent.
    - Increase in common-factor importance was larger for Canada than the United States.
  - Country-specific and idiosyncratic factors still account for substantial portions of volatility; country-specific factor accounted for more than 10 percent of volatility of each variable in the second period; idiosyncratic factor remains majority contributor.
- Policy implication for exchange rate:
  - Persistence of country-specific and idiosyncratic factors suggests significant benefits associated with exchange rate flexibility.

### V. Impact on productivity and labor productivity gap
- Aggregate patterns:
  - Labor productivity gap between Canada and the United States widened over the last two decades despite close integration.
  - Greater utilization of labor resources helped narrow per capita income gap from mid-1990s, but labor productivity growth in Canada remained more modest.
- Explanatory evidence:
  - ICT-producing sector:
    - Canada’s ICT-producing sector increased from around 2½ percent of GDP in 1981 to around 4 percent of GDP on average over the second half of the 1990s; U.S. share around 6 percent of GDP over this period.
    - ICT-capital deepening contribution estimates: Canada around ¼ percent to average annual labor productivity growth over 1995–2000; U.S. estimates between ½ percent and ⅔ percent.
  - SMEs and self-employment:
    - In Canadian manufacturing, SMEs (<500 employees) accounted for 75 percent of manufacturing employment vs around 60 percent in the United States in 1997.
    - Baldwin and Tang (2003): around ¼ percentage point of manufacturing labor productivity gap due to larger share of SMEs in Canada; ½ percentage point due to lower productivity of SMEs in Canada.
    - Faster growth of self-employment in Canada and poorer income performance of this group contributed to the gap.
  - Regulatory burden:
    - Empirical evidence does not reveal a large difference between Canada and the United States in labor and product market legislation/institutions, despite some index differences.
- Sectoral growth-accounting and TFP findings:
  - Labor productivity growth decomposition into capital deepening, labor quality and TFP used; TFP estimates constructed following Hall and Jones (1996) with industry conversion rates from Tang and Lee (2001).
  - Empirical results:
    - Canadian aggregate labor productivity grew by an average annual 0.3 percentage points less than in the United States over 1981–2000.
    - Gap widened to an average 0.8 percentage points in the post-1995 period.
    - Post-1995 widening occurred not only in ICT-producing sector but also in sectors that intensively used ICT capital.
    - Non–ICT producing manufacturing industries in Canada performed as well or better than U.S. counterparts.
    - Gaps emerged in trade and FIRE sectors: trade sector shortfalls in both TFP and capital deepening; FIRE sector gap due to smaller contribution of capital deepening than in the United States.
- TFP convergence evidence:
  - Positive correlation between average Canadian industry TFP growth and measures of openness to trade (vertical specialization and degree of trade exposure); correlation strengthened since inception of free trade agreement.
  - Autoregressive GMM estimation of log-TFP differentials:
    - Estimated β significantly less than 1, indicating convergence in TFP levels between Canada and the United States.
    - Estimated negative δ (significant at 10 percent) indicates the rate of convergence increased in the 1990s after Canada–U.S. FTA.
    - Faster convergence observed in the manufacturing sector (lower coefficients).
  - Supporting study: Sawchuk and Trefler (2002) — tariff cuts raised labor productivity by 3¼ percent per year in most affected manufacturing industries over 1989–95, and by ½ percent per year in the overall manufacturing sector.
  - Countervailing results: Harris and Kherfi (2000); Head and Reis (2003) report limited linkage between FTA and manufacturing specialization or TFP growth.
- Role of industrial structure in aggregate labor productivity gap:
  - Decomposition into direct, structural, and reallocation effects shows:
    - Significant part of widening labor productivity gap in post-1995 period is explained by structural differences (industry specialization shift).
    - Direct effect grew slightly more negative; structural and reallocation effects became negative contributors in post-1995 period.
  - Industry-specific contributions:
    - ICT-producing sector remained main contributor to aggregate gap across periods.
    - Negative contributions from trade and FIRE sectors rose significantly in second half of 1990s.
    - Negative contribution from ICT-producing manufacturing and trade sectors mainly due to lower labor productivity growth.
    - Negative contribution from FIRE sector largely due to lower relative size of sector in Canada.
- Overall interpretation:
  - Widening labor productivity gap over 1990s largely reflects differences in industrial structure rather than lack of benefits from trade.
  - Economic integration associated with convergence in total factor productivity and allowed Canadian firms to benefit from economies of scale and technology transfers.
  - Differences in industrial structure have prevented convergence in aggregate labor productivity.

### VI. Conclusions and policy implications
- Economic integration has been associated with:
  - Significant increase in business cycle synchronicity.
  - Convergence in total factor productivity.
- At the same time:
  - Substantial country-specific shocks persist due to differences in industrial structure.
  - Differences in industrial structure have prevented convergence in aggregate labor productivity.
- Policy implications highlighted:
  - Findings weigh against moving toward a monetary union.
  - Substantial benefits could be reaped from further reducing remaining barriers to trade (e.g., harmonizing rules, standards, and regulations).
  - Potential gains from further integration by removing remaining barriers: regulatory differences, security-related impediments, and rules-of-origin requirements.
  - Recent research cited suggests harmonization of MFN tariffs and removal of rules-of-origin could boost NAFTA’s GDP by as much as 2–3 percent (Policy Research Initiative, 2003).
  - Specific impediments noted: differences in regulatory frameworks impede trade and investment flows; security concerns slow cross-border goods flows; rules-of-origin requirements restrict trade flows.

### Selected empirical magnitudes and diagnostics (preserved exact values)
- Regional productivity growth example fragment: "5.3 percent for Quebec, 5 percent for the Prairies, and 4.7 percent for Atlantic Canada during" (fragment in source).
- Clausing (2001): more than half of the increase in Canada’s exports to the United States during 1989–94 attributed to CUSFTA.
- Wall (2003): NAFTA accounts for roughly 50 percent of the increase in the exports of Canada to the United States and approximately 25 percent of the increase in Canadian imports from the United States.
- Changes in trade composition (shares):
  - Share of manufactures in total exports: less than 33 percent in 1960 to roughly 63 percent in 2001.
  - Share of manufacturing imports: less than 70 percent in 1960 to roughly 83 percent in 2001.
- Financial flows:
  - Gross FDI flows increased by more than sevenfold between 1989 and 2002.
  - Average share of inflows from the United States accounted for 68 percent of total inflows over 1989–2002.
  - Average share of FDI inflows in Canada’s domestic gross fixed capital formation rose from 6 percent in the 1986–88 period to 26 percent over the 2000–02 period.
  - U.S. share of Canadian FDI stock remained around 65 percent.
- Variance decomposition diagnostics (selected entries from Table 4):
  - United States, Output, 60:1-81:2 — Common: 10.98 (33%), 14.29 (median), 17.93 (66%); Country: 13.64, 17.96, 22.49; Idiosyncratic: 61.60, 65.95, 70.36.
  - United States, Output, 81:3-02:4 — Common: 36.94, 42.92, 48.11; Country: 6.34, 10.60, 15.39; Idiosyncratic: 41.67, 45.26, 49.32.
- ICT capital and investment metrics (selected from Table 5):
  - Computers investment growth (1995-2001): 39.8 (Canada) / 39.3 (United States).
  - ICT capital services growth (1995-2001): ICT (Canada/United States) 18.4 / 21.3.
  - ICT share of capital income (2000): 8.3 (Canada), 15.3 (United States).
  - ICT share of capital stock (2000): 6.4 (Canada), 11.7 (United States).
- Productivity growth (Table 6, aggregates):
  - Total labor productivity growth (Canada, 1982-95): 1.6; Contribution from Capital: 0.8; Labor quality: 0.4; TFP: 0.4.
  - Total labor productivity growth (United States, 1982-95): 2.0; Contribution from Capital: 1.1; Labor quality: 0.3; TFP: 0.8.
  - Total labor productivity growth (Canada, 1995-2000): 2.0; Contribution from Capital: 1.1; Labor quality: 0.3; TFP: 0.8.
  - Total labor productivity growth (United States, 1995-2000): 1.6; Contribution from Capital: 0.9; Labor quality: 0.3; TFP: 0.4.
- TFP convergence estimation (Table 7, yearly data, 23 industries, 1981-2000):
  - Can-US (-1) coefficient: 0.79.
  - D CUSTA: -0.04 and -0.06 reported (p-values shown in source).
  - Number of observations: 414 and 252 (two reported columns).
  - Sargan test (p-value): 0.74 and 0.34.
  - AR(2) test (p-value): 0.59 and 0.21.
- Labor productivity gap decomposition (Table 8, in percent):
  - Direct Effect (aggregate): -0.4 (1982-2000), -0.3 (1982-95), -0.5 (1995-2000).
  - Structure effect: 0.0 (1982-2000), 0.1 (1982-95), -0.2 (1995-2000).
  - Reallocation effect: 0.0 (1982-2000), 0.1 (1982-95), -0.2 (1995-2000).

*Source: _wp04138 - References (excerpted content supplied).*

### References     .........................................................................................................

### _wp04138 - References

### I. Introduction — purpose and questions
- Paper analyzes impact of major Canada-U.S. trade agreements on business cycle dynamics and productivity.
- Central questions:
  - What has been the impact of the major trade agreements on trade and financial flows between the two countries?
  - What has been the effect of increased economic linkages on the comovement of business cycles in Canada and the United States?
  - How has economic integration affected the labor productivity gap between the two economies?

### Key milestones and institutional developments
- 1965 Canada-U.S. auto pact:
  - Eliminated tariffs on automotive products (prior tariffs roughly "7½ percent" in Canada and "17½ percent" in the United States).
  - Led to significant growth and integration of the Canadian auto industry.
- 1989 Canada-U.S. Free Trade Agreement (CUSFTA):
  - Introduced free trade in almost all sectors.
  - Average Canadian tariff on manufacturing imports from the United States fell from "3 percent" in 1989 to almost zero in 2001.
  - Average U.S. tariff on imports from Canada fell from around "4.5 percent" to "0.5 percent" during the same period.
  - Reduced nontariff barriers and provided rules covering services, investment, and dispute settlement mechanisms.
- 1994 North American Free Trade Agreement (NAFTA):
  - Broadened CUSFTA by including Mexico; NAFTA entered into force on "January 1, 1994."
  - In 2002, total GDP of NAFTA members was more than "25 percent" larger than that of the European Union.
  - Exports (imports) of the European Union constituted roughly "38 (35) percent" of world exports (imports) while exports (imports) of NAFTA accounted for about "18 (25) percent".
  - Eliminated the majority of tariffs in its first ten years and phased out most remaining tariffs by 2008.
  - Expanded coverage to investment flows, financial services, government purchases, and intellectual property rights.
  - Included side agreements: North American Agreement on Labor Cooperation and North American Agreement on Environmental Cooperation.
  - Preserved some sectoral protections (e.g., separate agricultural market access requirements) and comprehensive rules of origin; included safeguard clauses for import surges.

### III. Dynamics of trade and financial flows — stylized facts
- Growth of trade flows:
  - Canada’s merchandise trade to the United States more than doubled in U.S. dollar terms over the period 1988–2002.
  - Trade with the United States, on average, grew more than two times faster than GDP after the inception of CUSFTA.
  - Share of exports to the United States rose from around "30 percent" of GDP to as high as "55 percent" of GDP.
  - By 2002, roughly "90 percent" of Canadian merchandise exports were directed to the United States, a "17 percentage point" increase from 1988.
  - Share of Canadian imports from the United States remained roughly unchanged at around "65 percent" during the same period.
- Changes in product mix:
  - Transportation equipment, machinery and electronics continued to be significant but decreased in importance during 1989–92.
  - Share of exports associated with primary sectors (metals and minerals; wood and pulp) declined somewhat.
  - Sharp increases in apparel and textiles and special transactions; significant increase in share of exports from agriculture and oil sectors directed to the United States.
- National and regional effects within Canada:
  - Contribution of net exports to GDP growth jumped from about zero during 1973–88 to about "0.75 percentage points" after CUSFTA.
  - Regions previously weakly tied to U.S. market (British Columbia, the Prairies, the Atlantic region) saw sharp jumps in share of exports directed to the United States, narrowing gaps with Ontario and Quebec.
  - Average share of international trade in provincial GDP rose from "42 percent" in 1991 to "75 percent" in 2000.
  - Ontario’s exports to the United States rose from "25 percent" of its GDP in 1989 to almost "50 percent" in 2001.
- Regional gravity-model findings (selected results cited):
  - NAFTA resulted in large increase in trade volume between Central Canada (Ontario and Quebec) and the United States during 1993–97.
  - NAFTA led to a decrease in trade between Eastern Canada (New Brunswick, Newfoundland, Nova Scotia, Prince Edward Island).
  - Impact on trade flows from Western Canada (Alberta, British Columbia, Manitoba, Saskatchewan) to the United States was relatively minor.
  - Regional trade flows with the United States rose by "6.7 percent per year" for Ontario (Gu and Sawchuk (2001) result cited).

### IV. Business-cycle comovement and driving factors (summary of findings)
- Increased trade and financial linkages led to significant changes in dynamics of Canada’s business cycles.
- Canada-U.S. business cycles have become more synchronized; rapid growth of intra-industry trade contributed to greater cross-country correlations of investment and imports.
- Dynamic latent factor model results:
  - The common factor has played an increased role in explaining business cycles in Canada and the United States since the early 1980s.
  - Country-specific and idiosyncratic factors remain important in Canada.

### V. Impact on productivity and labor productivity gap
- Widening labor productivity gap in the 1990s mainly reflects different evolution of industrial structure between the two countries.
- Different industry specialization did not seem to be related to increased trade integration over the 1990s.
- Economic integration allowed Canadian firms to benefit from economies of scale and technology transfers, which appears to have positively contributed to their productivity performance.
- Results indicate:
  - Economic integration associated with convergence in total factor productivity.
  - Differences in industrial structure have prevented convergence in aggregate labor productivity.

### VI. Conclusions and policy implications
- Economic integration has been associated with:
  - Significant increase in business cycle synchronicity.
  - Convergence in total factor productivity.
- At the same time:
  - Substantial country-specific shocks persist due to differences in industrial structure.
  - Differences in industrial structure have prevented convergence in aggregate labor productivity.
- Policy implications highlighted:
  - Findings weigh against moving toward a monetary union.
  - Substantial benefits could be reaped from further reducing remaining barriers to trade (e.g., harmonizing rules, standards, and regulations).

*Source: _wp04138 - References (excerpted content supplied).*

### 5.3 percent for Quebec, 5 percent for the Prairies, and 4.7 percent for Atlantic Canada during

### _wp04138 - 5.3 percent for Quebec, 5 percent for the Prairies, and 4.7 percent for Atlantic Canada during

### Impact of CUSFTA/NAFTA on Canada–U.S. trade flows
- Clausing (2001) concludes that more than half of the increase in Canada’s exports to the United States during 1989–94 was due to CUSFTA.
- Romalis (2002) confirms that CUSFTA has had a large impact on Canada’s trade share with the United States via tariff preference associated with CUSFTA and NAFTA.
- Wall (2003) finds NAFTA accounts for roughly 50 percent of the increase in the exports of Canada to the United States and approximately 25 percent of the increase in Canadian imports from the United States.
- Scholarly disagreement on trade diversion:
  - Clausing (2001): no sizeable trade diversion.
  - Romalis (2002) and Wall (2003): agreements induced trade diversion.
- Sectoral evidence:
  - Schwanen (1997): exports of Canada to the United States in sectors liberalized after CUSFTA and NAFTA rose by 139 percent versus 64 percent in other sectors.
  - Trefler (2001), Head and Reis (2003), Krueger (1999, 2000): CUSFTA/NAFTA had positive effects on trade flows.

### Changes in the nature of trade
- Structural shift toward manufactures (shares in total trade):
  - Share of manufactures in total exports rose from less than 33 percent in 1960 to roughly 63 percent in 2001.
  - Share of manufacturing imports rose from less than 70 percent in 1960 to roughly 83 percent in 2001.
- ICT-producing sector:
  - Canada’s ICT-producing sector increased its share of aggregate GDP over the second half of the 1990s, but remains lower than in the United States (Table 3 referenced).
- Sectoral contributions to Canada–U.S. trade growth (1990–98):
  - Electronic equipment, industrial machinery, and motor vehicles accounted for half of the increase in Canada’s trade flows with the United States.
  - Fast growth of electronic equipment and industrial machinery explained more than 50 percent of the increase; resource and resource-based industries accounted for roughly 20 percent of the increase.
- Vertical integration and intra-industry trade:
  - Share of Canada’s exports based on vertical trade rose by twofold since the inception of CUSFTA (Figure 4d).
  - Dion (1999): dramatic increase in vertical specialization across manufacturing industries since the late 1980s.
  - Hummels, Rapaport, and Yi (1998): 1965 U.S.-Canada Auto Agreement led to substantial increase in vertical trade in the auto industry.
  - Intra-industry trade accounts for most of trade in almost all industries between Canada and the United States.
  - Example: share of intra-industry trade in machinery rose from 62 percent in 1990 to 67 percent in 1998 (Sawchuk and Sydor, 2003).
  - Recent research: unable to establish a clear link between CUSFTA/NAFTA and increase in intra-industry trade during the 1990s (Trefler, 2001; Acharya, Sharma, and Rao, 2003).

### Growth of financial flows
- Gross FDI flows increased by more than sevenfold between 1989 and 2002, with similar increases in both directions (Figure 5a).
- Average share of inflows from the United States accounted for 68 percent of total inflows over the period 1989–2002.
- Average share of FDI inflows in Canada’s domestic gross fixed capital formation (investment) rose from 6 percent in the 1986–88 period to 26 percent over the 2000–02 period (Figure 5b).
- Tremendous increase in FDI flows after the inception of NAFTA, associated with a small number of mega-mergers (DFAIT 2003).
- Recent research (Schwanen, 1997; Globerman and Shapiro, 2003) finds no discernible impact of CUSFTA/NAFTA on FDI flows between the two countries.
- Note: U.S. share of Canadian FDI stock remained around 65 percent despite increased flows.

### Economic integration and the dynamics of business cycles
- Theoretical ambiguity: increased trade can raise or lower business cycle comovement depending on intra- versus inter-industry trade and nature of shocks.
- Empirical evidence on synchronization is mixed:
  - Studies reporting increased synchronization: Kose, Prasad, and Terrones (2004); Kose, Otrok, Whiteman (2004); Stock and Watson (2003).
  - Studies reporting no major change: Doyle and Faust (2003); Helbling and Bayoumi (2003); Heathcote and Perri (2003).
- Simple correlations:
  - 20-year rolling correlations show increased comovement of Canada’s output, consumption, and investment with U.S. counterparts, particularly investment and imports after CUSFTA (Figures 6 and 7).
  - Canada and U.S. cycles became less correlated with cycles in Germany and Japan.
- Dynamic latent factor model (Kose, Otrok, and Whiteman, 2004) decomposition:
  - Factors: common factor (f_common), country-specific factors (f_country per country), and idiosyncratic errors (ε_i,t).
  - Observables: output, consumption and investment for four countries (12 time series); sample t=1960Q1-2002Q4.
- Factor findings:
  - Common factor tracked major global cycle episodes since 1960 (1960s expansion, early 1970s boom, recessions mid-1970s/early 1980s/1990s, late 1980s expansion, global downturn 2001–02).
  - Canada-specific factor explains Canadian recessions of 1982 and 1991, slowdown in 2001, and booms of 1960s and late 1990s.
  - U.S. country factor captures NBER reference cycle dates and the synchronized severe downturn in 2000.
- Variance decomposition results:
  - Over 1960Q1–2002Q4, common factor explains about 10 percent of Canada’s output volatility; country and idiosyncratic factors explain bulk of volatility (Figure 9a).
  - Common factor more important in Germany and Japan, explaining more than 25 percent of output volatility in Japan.
  - Comparing 1960Q1–1981Q2 vs 1981Q3–2002Q4:
    - Share of Canada’s output variance explained by common factor roughly tripled in the later period (Figure 9b).
    - Share of investment due to common factor rose fourfold; consumption share due to common factor increased from less than 5 percent to roughly 40 percent (Figures 9c and 9d).
    - Increase in common-factor importance was larger for Canada than the United States.
  - Country-specific and idiosyncratic factors remain important:
    - Country-specific factor still accounted for more than 10 percent of volatility of each variable in the second period.
    - Majority of business cycle variation still attributed to idiosyncratic factor (Table 4).
    - Country-specific and idiosyncratic factors explained over 50 percent of business cycle variation in the United States.
- Implications for exchange rate policy:
  - Persistence of country-specific and idiosyncratic factors suggests significant benefits associated with exchange rate flexibility.
  - Studies cited: Murray, Schembri, and St-Amant (2003); Carr and Floyd (2002); Arora and Jeanne (2001).
- Volatility dynamics:
  - Volatility of Canadian business cycle fluctuations fell during the 1990s (Figure 10).
  - Debb (2001): structural break in volatility of Canadian real GDP growth in 1991Q1.
  - U.S. real GDP growth volatility declined since mid-1980s; Japan exception with increased output volatility in the past decade.
  - Explanations: “new economy,” shift to services, improved inventory management, increased effectiveness of monetary policy (Debb, 2001; Blanchard and Simon, 2001).

### Economic integration and productivity
- Aggregate labor productivity gap:
  - Labor productivity gap between Canada and the United States widened over the last two decades despite close integration (Figure 11).
  - Greater utilization of labor resources helped narrow per capita income gap from mid-1990s, but labor productivity growth in Canada remained more modest.
- Explanations explored in literature:
  - Size of ICT-producing sector:
    - Canada’s ICT-producing sector increased from around 2½ percent of GDP in 1981 to around 4 percent of GDP on average over the second half of the 1990s; U.S. share around 6 percent of GDP over this period (Harchaoui and Tarkhani, 2002).
  - Contribution from ICT capital accumulation:
    - Canada’s business sector experienced solid growth in ICT capital services over 1981–2000, at levels comparable to or higher than the United States (Table 5), but contribution to labor productivity growth lower in Canada due to lower estimated marginal productivity of ICT capital and lower ICT capital intensity.
    - ICT-capital deepening contribution estimates: Canada around ¼ percent to average annual labor productivity growth over 1995–2000; U.S. estimates between ½ percent and ⅔ percent (Oliner and Sichel, 2002; Jorgenson, Ho, and Stiroh, 2004).
  - Small and medium enterprises (SMEs):
    - In Canadian manufacturing, SMEs (<500 employees) accounted for 75 percent of manufacturing employment vs around 60 percent in the United States in 1997.
    - Baldwin and Tang (2003): around ¼ percentage point of manufacturing labor productivity gap due to larger share of SMEs in Canada; ½ percentage point due to lower productivity of SMEs in Canada.
  - Self-employment:
    - Faster growth of self-employment in Canada and poorer income performance of this group compared with the United States contributed to the gap (Baldwin and Chowhan, 2003).
  - Regulatory burden:
    - Empirical evidence does not reveal a large difference between Canada and the United States in labor and product market legislation/institutions, despite some index differences (Gust and Marquez, 2004).
- Sectoral growth accounting framework:
  - Labor productivity growth (value added per hours worked, y_t) decomposed into labor quality (H_t) weighted by labor income share (β_t), capital deepening (k_t) weighted by capital income share (α_t), and total factor productivity (TFP, A_t).
  - Log-TFP differentials computed following Hall and Jones (1996), with Canada value added and capital stock in U.S. dollars using industry conversion rates from Tang and Lee (2001).
  - Labor and capital inputs adjusted for quality changes; TFP estimates aim to proxy technical and organizational change.
- Key empirical results from Table 6 and related analysis:
  - Canadian aggregate labor productivity grew by an average annual 0.3 percentage points less than in the United States over 1981–2000.
  - Gap widened to an average 0.8 percentage points in the post-1995 period.
  - Post-1995 widening occurred not only in ICT-producing sector but also in sectors that intensively used ICT capital.
  - Non–ICT producing manufacturing industries in Canada performed as well or better than U.S. counterparts.
  - Gaps emerged in trade and FIRE sectors: trade sector shortfalls in both TFP and capital deepening; FIRE sector gap due to smaller contribution of capital deepening than in the United States.
- Effect of free trade agreements on productivity convergence:
  - Positive correlation between average Canadian industry TFP growth and measures of openness to trade (vertical specialization and degree of trade exposure); correlation strengthened since inception of free trade agreement.
  - Autoregressive GMM estimation (Arellano and Bond) of log-TFP differentials with CUSTA dummy:
    - Estimated β significantly less than 1, indicating convergence in TFP levels between Canada and the United States.
    - Estimated negative δ (significant at 10 percent) indicates the rate of convergence increased in the 1990s after Canada–U.S. FTA.
    - Faster convergence observed in the manufacturing sector (lower coefficients).
  - Supporting evidence:
    - Sawchuk and Trefler (2002): tariff cuts raised labor productivity by 3¼ percent per year in most affected manufacturing industries over 1989–95, and by ½ percent per year in the overall manufacturing sector.
  - Countervailing findings:
    - Harris and Kherfi (2000): failed to identify positive link between trade specialization and TFP growth in Canada.
    - Head and Reis (2003): Canada’s manufacturing specialization hardly changed under FTA.
- Role of industrial structure in aggregate labor productivity gap:
  - Decomposition into three components:
    - “Direct” effect: industry i’s different labor productivity growth performance weighted by average value-added share.
    - “Structural” effect: industry i’s different relative size across two countries weighted by average labor productivity growth.
    - “Reallocation factor”: differing ability to move labor resources toward sectors with higher-than-average labor productivity (hours worked allocation).
  - Findings (Table 8):
    - Significant part of widening labor productivity gap in post-1995 period is explained by structural differences (industry specialization shift).
    - Direct effect grew slightly more negative; structural and reallocation effects became negative contributors in post-1995 period.
  - Industry-specific contributions (Figure 13):
    - ICT-producing sector remained main contributor to aggregate gap across periods.
    - Negative contributions from trade and FIRE sectors rose significantly in second half of 1990s.
    - Negative contribution from ICT-producing manufacturing and trade sectors mainly due to lower labor productivity growth.
    - Negative contribution from FIRE sector largely due to lower relative size of sector in Canada.
- Overall interpretation:
  - Widening labor productivity gap over 1990s largely reflects differences in industrial structure rather than lack of benefits from trade.
  - Increased two-way and vertical specialization trade allowed Canadian firms to benefit from economies of scale and technology transfer, contributing positively to TFP in many sectors.
  - However, U.S. advantage in service sector shares amplified aggregate gains in labor productivity in the United States.

### Policy-relevant findings and recommendations
- Exchange rate policy:
  - Continued importance of country-specific and idiosyncratic shocks supports benefits from exchange rate flexibility for Canada.
- Deepening economic linkages:
  - Potential gains from further integration by removing remaining barriers: regulatory differences, security-related impediments, and rules-of-origin requirements.
  - Recent research cited suggests harmonization of MFN tariffs and removal of rules-of-origin could boost NAFTA’s GDP by as much as 2–3 percent (Policy Research Initiative, 2003).
- Specific impediments noted:
  - Differences in regulatory frameworks impede trade and investment flows.
  - Security concerns slow cross-border goods flows; initiatives like the Smart Border Action Plan and Free and Secure Trade (FAST) program aim to harmonize procedures.
  - Rules-of-origin requirements restrict trade flows; harmonization and liberalization of rules of origin and MFN tariffs could yield large gains (Estevardeordal and Suominen, 2004; Mirus and Hoffman, 2004; Ghosh and Rao, 2004).

*Italic: Content derived from the supplied IMF chapter/section text.*

### Appendix 1: Data Sources

### Appendix 1: Data Sources

### Data for Canada
- Real (chain Fisher weighted) value added, hours worked, labor input, and capital services data were obtained from Statistics Canada and were based on a SIC-80 industry classification.
- For the manufacturing sectors, however, the data ended in 1997. They were extrapolated to 2000 using the growth rates from the KLEMS input and output database which follows a NAICS industry classification (starting from 1997).
- Comparing the 1997 industries’ value added based on the two industry classifications shows that the difference is generally around 15 percent, except for “other manufacturing sector” and “furniture and fixture,” for which the difference is around 30 percent. The results for these sectors should then be interpreted with greater caution than others.

### Data for the United States
- Industry data for the United States follows the US SIC 87 industry classification.
- Real (chain Fisher weighted) value added industry data for the United States were obtained from Bureau of Economic Analysis’s “gross product originating” by industry (GPO). As these figures are on a market-price basis, value-added data at basic prices were obtained by subtracting the indirect business tax and nontax liability from GPO.
- GDP by industry is obtained from industries components of domestic income which, as it is well known, tend to falls short of GDP measured on an expenditure basis. The difference is named “statistical discrepancy,” and is attributed to the industries based on their share of total GDP.
- Hours worked, labor input and capital services were obtained from Jorgenson, Ho, and Stiroh (2004), and are based on methodologies that are largely comparable with those adopted by Statistics Canada.

### Industry classification and aggregation
- To obtain the same level of industry classification for the two countries a number of subsectors were aggregated into larger sectors. As an example, a “mining” sector was obtained for the Unites States by aggregating four subsectors (namely, metal mining, coal mining petroleum and gas and nonmetallic mining).
- The aggregation was needed also to obtain comparable sectors for the two countries. For example, US SIC 87 classification places computers and office equipment in Industrial Machinery, while Canada SIC 80 classification places it in the Electrical and Electronic equipment. For the sake of comparison, the two sectors were aggregated into one large sector, which is taken as a proxy for the ICT-producing sector in the paper.
- The following aggregation criteria were utilized:
  - sub-industries value-added were aggregated using value-added shares as weights;
  - labor and capital inputs were aggregated using relative shares in aggregate labor compensation and capital income, respectively, as weights;
  - hours worked were aggregated through the unweighted sum.
- Despite following these aggregation procedures allows to obtain reasonably comparable sectors for the two countries, some minor differences still persist, particularly in the service sectors. In addition to the different treatment of eating and drinking places (see footnote 25 in the text), another difference which is worth mentioning regards postal services, which are placed in the Communication sector for Canada but in the Transportation sector for the United States.

*Source: Appendix 1: Data Sources*

### REFERENCES

### REFERENCES

### Key empirical findings from tables
- Table 1: Canada: Merchandise Trade with the United States (Share of Total Exports and Imports in percent)
  - Exports (1989–2002 Change (1989-2002)):
    - Transportation Equipment: 32.8, 27.0, -5.8
    - Machinery & Electronics: 14.6, 13.7, -0.9
    - Metals & Minerals: 21.3, 21.7, 0.4
    - Wood & Pulp: 15.0, 10.5, -4.5
    - All Others: 16.4, 27.1, 10.7
  - Imports:
    - Transportation Equipment: 28.1, 25.6, -2.5
    - Machinery & Electronics: 33.6, 30.6, -3.0
    - Metals & Minerals: 11.3, 10.9, -0.4
    - Chemicals & Plastic & Rubber: 10.0, 14.8, 4.8
    - All Others: 17.0, 18.2, 1.2
  - Source: DFAIT (2003).

- Table 2: Canada: Composition of Trade (Share of Total Exports and Imports in Percent)
  - Exports (1960 / 1980 / 2001):
    - Manufactures: 32.5, 48.1, 62.4
    - Agriculture & Food: 36.5, 23.4, 13.0
    - Fuel & Ores: 30.4, 28.1, 18.5
  - Imports (1960 / 1980 / 2001):
    - Manufactures: 69.0, 71.7, 82.9
    - Agriculture & Food: 16.2, 9.6, 7.0
    - Fuel & Ores: 12.3, 17.2, 7.9
  - Source: World Bank, World Development Indicators.

- Table 3: Canada and the United States: Value-Added, Shares of Total (In percent)
  - Periods compared: 1981-95 versus 1995-2000
  - Notable sectoral shares (examples):
    - Manufacturing (Canada): 24.0 (1981-95), 25.1 (1995-2000)
    - FIRE (Canada): 12.8 (1981-95), 14.3 (1995-2000)
    - Other Services (Canada): 15.9 (1981-95), 18.0 (1995-2000)
  - Of manufacturing, Industrial Machineries and Electrical and Electronic equipment (Canada): 2.7 (1981-95), 2.9 (1995-2000).

- Table 4: Variance Decompositions (Percent of variance explained; 33% and 66% confidence intervals reported)
  - United States, Output, 60:1-81:2:
    - Common: 10.98 (33%), 14.29 (median), 17.93 (66%)
    - Country: 13.64, 17.96, 22.49
    - Idiosyncratic: 61.60, 65.95, 70.36
  - United States, Output, 81:3-02:4:
    - Common: 36.94, 42.92, 48.11
    - Country: 6.34, 10.60, 15.39
    - Idiosyncratic: 41.67, 45.26, 49.32
  - Canada, Output and other series have analogous decompositions reported in the table.
  - Notes: 33 percent and 66 percent refer to the confidence intervals of the median. Source: Fund staff calculations.

- Table 5: Canada and the United States: ICT Capital Accumulation (Values are for 1981 and 2000; In percent)
  - Investment (average rate of growth), 1995-2001:
    - Computers (Canada/United States): 25.8 / 28.0 (1981-95 baseline?) and 39.8 / 39.3 (1995-2001)
    - Software: 19.2 / 16.6 (1981-95) and 10.2 / 19.8 (1995-2001)
    - Communications: 4.5 / 4.8 (1981-95) and 17.9 / 12.2 (1995-2001)
  - Capital services (average rate of growth):
    - All assets (Canada/United States): 3.0 / 3.4 (1981-95) and 4.3 / 5.4 (1995-2001)
    - ICT (Canada/United States): 16.9 / 14.9 (1981-95) and 18.4 / 21.3 (1995-2001)
  - ICT share metrics:
    - ICT share of capital income 2/: 6.3 (Canada 1981), 10.9 (United States 1981), 8.3 (Canada 2000), 15.3 (United States 2000)
    - ICT share of capital stock 3/: 3.9 (Canada 1981), 7.0 (United States 1981), 6.4 (Canada 2000), 11.7 (United States 2000)
  - Sources: Haver Analytics; Harchaoui and Tarkhani (2002); Armstrong et al. (2002) for Canada and BEA for the United States.

- Table 6: Canada and the United States: Productivity Growth, 1982-2000 (and subperiods)
  - Aggregate totals reported:
    - Total labor productivity growth (Canada, 1982-95): 1.6; Contribution from Capital: 0.8; Labor quality: 0.4; TFP: 0.4
    - Total labor productivity growth (United States, 1982-95): 2.0; Contribution from Capital: 1.1; Labor quality: 0.3; TFP: 0.8
    - Total labor productivity growth (Canada, 1995-2000): 2.0; Contribution from Capital: 1.1; Labor quality: 0.3; TFP: 0.8
    - Total labor productivity growth (United States, 1995-2000): 1.6; Contribution from Capital: 0.9; Labor quality: 0.3; TFP: 0.4
  - Sector-level contributions to labor productivity and decomposition into Capital, Labor quality, and TFP are reported for many industries (examples preserved in the source tables).

- Table 7: Estimation of TFP Convergence Equation (Yearly data, 23 industries, 1981-2000)
  - All sectors:
    - Can-US (-1) coefficient: 0.79 (standard errors not shown)
    - (*TFP Can-US (-1)): -0.06 (p-values in parentheses: (0.00) for first, (0.00) for second reported entry)
    - D CUSTA: -0.04 and -0.06 with p-values (0.00) and (0.00) respectively
  - No. of observations: 414 and 252 (two reported columns)
  - Sargan test (p-value): 0.74 and 0.34
  - AR(2) test (p-value): 0.59 and 0.21
  - Notes: Dependent variable: log-TFP differential (Canada minus United States). Year dummies not reported. Numbers in brackets are p-values, based on heteroskedastic robust standard errors.

- Table 8: Canada - U.S. Labor Productivity Growth Gap (In percent)
  - Contribution breakdowns 1982-2000, 1982-95, 1995-2000:
    - Direct Effect (aggregate): -0.4 (1982-2000), -0.3 (1982-95), -0.5 (1995-2000)
    - Of which Industrial Machinery and Electrical and Electronic equip.: -0.2, -0.2, -0.4
    - Transportation equipment: 0.1, 0.0, 0.1
    - Trade: -0.2, 0.0, -0.4
    - FIRE: 0.1, -0.1, 0.0
    - Other Services: 0.0, 0.0, 0.1
    - Structure effect: 0.0, 0.1, -0.2
    - Reallocation effect: 0.0, 0.1, -0.2
  - Source: Fund staff estimates.

### Key graphical empirical summaries (figures)
- Figures on tariffs:
  - Figure 1 (United States): United States: Average Tariffs on Imports from Canada and World — plotted 1989–2001, vertical axis Tariff Rate (%).
  - Figure 2 (Canada): Canada: Average Tariffs on Manufacturing Imports from the U.S. and Rest of World — plotted 1989–2000, vertical axis Tariff Rate (%).

- Figures on trade, GDP, and shares:
  - Figure 3a: Trade with the U.S. and GDP (Index, 1980 = 100) showing Imports, Exports, GDP indexed 1980–2002.
  - Figure 3b: Trade with the U.S. as a Share of GDP (percent) 1960–2002, series for Imports, Exports, Total.
  - Figure 3c: Trade with the U.S. as a Share of Total (percent) 1960–2002, Imports and Exports.
  - Figure 3d: Canada: Sectoral Exports to the U.S. (Percent of Total Sectoral Exports) comparing 1989 and 2002 across sectors.

- Figures on regional and sectoral trade patterns:
  - Figure 4b and 4c: Exports to the U.S. by Region; Regional Exports to the U.S. (percent of total regional exports and percent of total Canadian exports), 1989 and 2002.
  - Figure 4d: Vertical Specialization — Processed Imports as a Share of Sectoral Merchandise Exports, averaged by period (1961-1980, 1981-1988, 1989-2002).

- Figures on FDI:
  - Figure 5a: Canada-U.S. FDI Flows (Outward and Inward, Billion C$) plotted 1980–2002.
  - Figure 5b: Canada: FDI Flows as a Fraction of Domestic Investment (percent) plotted 1980–2001 (FDI Inflows, FDI Outflows).

- Figures on comovement and volatility:
  - Figure 6: Canada and the United States: Comovement of Economic Variables — 20-year Rolling Correlations for Output, Consumption, Investment, 1980–2002.
  - Figure 7: Canada and the United States: Comovement of Economic Variables — Correlation Coefficients for GDP, Consumption, Investment, Exports, Imports comparing 60:1-88:4 and 89:1-02:4.
  - Figure 10: Canada: Volatility of Business Cycles — Standard Deviation (percent) for GDP, Consumption, Services, Investment, Exports, Imports comparing 61:2-88:4 and 89:1-02:4.

- Figures on factor structure and variance contributions:
  - Figure 8a–c: World Factor; Canada Factor and GDP; United States Factor and GDP — Growth Rates in Percent, 1960–2000.
  - Figure 9a–d: Fraction of Variance Explained by Common, Country, Idiosyncratic factors; and fraction of variance explained by the Common Factor across Output, Consumption, Investment for Canada, United States, Germany, Japan and subperiods 60:1-81:2 and 81:3-02:4.

- Figures on income/productivity and cross-sectional relationships:
  - Figure 11: United States and Canada: Income and Productivity Indicators — Labor Utilization, Per capita income, Labor productivity (United States = 100), 1976–2002.
  - Figure 12a–d: Trade Exposure and TFP Growth; Vertical Integration and TFP Growth — sectoral scatter plots and fitted lines for averages 1981-2000 and 1990-2000.
  - Figure 13: Sectoral Contributions to the Canada - U.S. Aggregate Labor Productivity Growth Gap (In percent) for 1981-1995 and 1995-2000 (sector bars and scales preserved in source figures).

### Data and methodology notes evident in the content
- Time coverage varies across tables and figures; examples include:
  - Annual and quarterly series covering 1960–2002 and 1980–2002 for many series.
  - Industry-level yearly data covering 1981–2000 for TFP convergence estimation across 23 industries.
- Sources cited within tables and figure notes include DFAIT (2003), World Bank World Development Indicators, Haver Analytics, Harchaoui and Tarkhani (2002), Armstrong et al. (2002), BEA, and Fund staff estimates.
- Statistical outputs reported with exact diagnostics where applicable:
  - Table 7 reports Sargan test (p-value): 0.74 and 0.34; AR(2) test (p-value): 0.59 and 0.21; number of observations: 414 and 252.
  - Variance decomposition confidence interval percentiles explicitly reported as 33% and 66%.

*Source: _wp04138 - REFERENCES.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2004/_wp04138.pdf_