## 1. Path for Potential Output Growth Components

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### Introduction — context and headline projections
- Potential output is central to assessing economic slack and timing of exit strategies from policy stimulus.
- Crisis-related uncertainty elevated because capital accumulation, equilibrium unemployment rates, and total factor productivity (TFP) are affected by severe financial shocks and sectoral reallocation.
- Key projected impacts for Canada amid the crisis:
  - Potential GDP growth would decline significantly in the coming years amid the crisis (by almost 1 percentage point).
  - Potential GDP growth would gradually rise to around 2 percent by 2014 (below the estimated 2.4 percent potential growth for 2008).
  - Potential GDP level would suffer a permanent decline of about 2½ percent vis-à-vis a no-crisis scenario.
- Recent observed movements influencing potential:
  - Investment is down almost 15 percent since end-2008Q2.
  - Protracted recession and tighter financial conditions have already hurt investment and capital accumulation, while higher unemployment will affect equilibrium unemployment rates.

### Theoretical channels through which the crisis affects potential output
- Labor input
  - Net short-term effect ambiguous: recession could reduce labor participation and migration but depleted household savings could encourage longer working lives or secondary earners to enter the labor market.
  - Expectation of a temporary increase in NAIRU via hysteresis effects.
  - Canada’s labor market flexibility suggests NAIRU and participation effects may be temporary.
  - Demographics will contribute negatively to potential growth beyond the crisis.
- Capital accumulation
  - Financial crises lower incentives to invest by decreasing sales and raising uncertainty over returns and risk premia.
  - Credit supply is generally lower during a financial crisis as financial institutions repair balance sheets.
  - Canada experienced a large drop in investment since mid-2008, implying slower growth in the capital stock and potential growth.
  - Longer-term investment effects depend on persistence of high capital costs and investor risk attitudes.
- Total factor productivity (TFP)
  - Uncertain a priori:
    - Negative channel: uncertainty and higher capital costs deter private R&D and innovation; private R&D investment is low in Canada in international comparisons.
    - Positive channel: firms may undertake reforms and restructuring to improve efficiency.
  - Industry heterogeneity matters; empirical evidence for 1990–2007 (31 industries, US and Canada) shows financial shocks tended to lower TFP growth.

### Empirical evidence on financial crises and potential output
- Cross-country estimates and magnitudes:
  - Furceri and Mourougane (2009): average permanent potential GDP level loss 1.5–2.4 percent after financial crises.
  - Cerra and Saxena (2008): permanent output loss 4 to 16 percent.
  - European Commission (2009): each year of a banking crisis (average length 3.9 years) associated with drop in potential GDP per capita growth of around 0.5 percentage point.
  - Reinhart and Rogoff (2009): financial-crisis recessions last longer than typical episodes by an average of one year.
  - Haugh et al. (2009): output losses during financial crises typically two to three times greater than during “normal recessions,” with protracted recoveries.
- Canadian historical experience:
  - Past financial downturns had severe and long-lasting effects on Canadian output (1980s recession; 1991 recession).
  - Onset of current crisis: FIRE’s growth rate decelerated significantly but did not turn negative, averaging around 1 percent for the last year.

### Productivity developments and sectoral patterns in Canada’s business sector
- Long-run and recent labor productivity trends:
  - Over the past 50 years, productivity in Canada has increased by around 2 percent per year, compared with 2.3 percent in the United States.
  - 2000 to 2008: labor productivity in Canada's business sector increased at an annual average rate of 0.7 percent versus 2.6 percent in the United States.
  - 1961–1980: Canadian labor productivity increased 2.9 percent a year on average, compared with 2.5 percent in the United States.
  - 1997–2000: Canadian labor productivity grew by 3.2 percent before decelerating to 1.1 percent and declining by 1 percent in 2008.
- TFP dynamics and comparisons:
  - Baldwin and Gu (2009): recent slowdown in labor productivity largely explained by slower TFP growth.
  - Canadian TFP average growth:
    - 1980–2000: grew by an annual average of 0.3 percent.
    - 2000–08: declined by 0.6 percent.
  - United States TFP (1996–2006) at 1.5 percent a year versus Canadian figure 0.6 percent a year.
  - Baldwin and Gu estimate the average annual growth rate of TFP in the United States over 1961–2008 was 0.9 percentage points higher than in Canada.
- Sectoral contributions and shifts:
  - Studies differ: U.S. service-sector acceleration (trade and FIRE) explains much of the gap (Cardarelli and Kose, 2004); Baldwin and Gu attribute Canadian slowdown to mining, oil and gas extraction (0.6 percentage point of post-2000 deceleration) and manufacturing (0.5 percentage point); FIRE accounts for 0.2 percentage point.
  - Recent outcomes:
    - 2008 decline in labor productivity originates mostly from goods-producing sector, which contracted by almost 3 percent (construction and manufacturing driven).
    - Construction rose by over 5 percent through the year ending in the second quarter of 2009.
    - Services sector labor productivity averaged -0.2 percent in the last three quarters, with large declines in wholesale trade and FIRE.
    - Overall, Canada’s business labor productivity was unchanged year-on-year at the end of the second quarter of 2009.
  - Structural shifts: manufacturing share of real GDP at basic prices fell from around 18 percent in the early 2000s to around 13 percent; mining and oil extraction’s share around 4 to 5 percent.

### NAIRU in Canada — estimates, drivers and recent evolution
- Historical perspective:
  - Consensus that NAIRU had been declining up to the beginning of the current crisis.
  - Estimates and findings vary: OECD mid-1990s estimates ranged from 9.5 percent to 6.5 percent (average 7.7 percent); Fortin (2000) estimated LSRU around 6 percent by 2000.
- Recent labor-market dynamics:
  - Unemployment rate increased from 6.2 percent in September 2008 to 8.6 percent in October 2008.
- Drivers of the 1990s decline in NAIRU:
  - Drop in relative size of youth labor force; higher average education; deregulation; free trade and globalization; decline in unemployment insurance generosity.
  - Increased female labor force participation and tax/benefit reforms increased participation of secondary earners.
- Recent movements and crisis effects:
  - Authors’ HP-filter-based NAIRU estimates observe a declining trend in the 1990s and 2000s; NAIRU could have fallen to around 6 percent only by 2008.
  - Crisis expected to raise NAIRU temporarily due to human capital depletion; expected to return to pre-crisis levels over the medium term given labor market flexibility.

### Demographics and population projections relevant for potential
- Stats Canada’s baseline projections:
  - Between 2006 and 2011, working-age population will rise by a cumulative 4.4 percent versus over 13 percent increase in the elderly population.
  - By 2031, the elderly population more than doubles (compared to 2006) while the size of the working-age population only increases by 8 percent.

### Simple decomposition framework and measurement
- Potential GDP growth decomposed into changes in:
  - capital stock;
  - equilibrium capital utilization;
  - trend hours of work per employee;
  - equilibrium rate of unemployment (NAIRU);
  - trend labor force participation rate;
  - working-age population;
  - trend TFP.
- TFP level (log form) used:
  - tfp = y - α ks - α ku - (1-α) l     (1)
- Potential output calculation (log form) used:
  - y* = α ks + α ku* + (1-α) h* + (1-α) (1-u*) + (1-α) lfp* + (1-α) wap + tfp*     (2)
- Trend values obtained using an HP filter with smoothness parameter λ = 100.
- Parameter and data choices:
  - average share of labor compensation in value added as proxy for (1-α) = 0.62.
  - capital data from OECD Economic Outlook; labor data from Statistics Canada’s Labor Force Survey.
- Assumptions and methodological notes:
  - Output-labor elasticity assumed to be 0.6 and output-capital elasticity assumed to be 0.4.
  - Trend capacity utilization calculated using data from Stats Canada (detrended by HP-filter).
  - NAIRU: HP filter of civilian unemployment rate, 15-64 years (seasonally adjusted).
  - Trend labor force participation rate calculated by HP filter of the ratio between labor force and working-age population.
  - Working-age population refers to Canadian population "16-65 years of age."

### Assumptions and projections for the crisis and medium term
- Investment and capital
  - October 2009 WEO forecast: gross private fixed investment declining by 13.5 percent in 2009.
  - By mid-2009 investment was 14.8 percent lower than a year ago.
  - For 2010: gross private fixed investment expected to remain at 2009 levels.
  - Investment returns slowly to near pre-crisis ratios to output by end of forecast horizon at around 17.3 percent of nominal GDP.
  - Historical rate of depreciation around 8 percent a year used in perpetual inventory method.
  - Canadian firms raise around 25 percent of their capital from U.S. sources.
  - Equilibrium capacity utilization in non-farm goods-producing industries assumed essentially constant for the forecast period.
- Labor and demographics
  - Labor force participation assumed essentially unchanged over medium term (negligible rise possible).
  - Growth in working-age population (age 16–65) set to decline slowly per Statistics Canada baseline projections.
  - Average hours of work assumed to continue long-term downward trend.
  - Trend aggregate TFP growth assumed essentially unchanged through the crisis with minor decline over medium term.
- NAIRU path
  - HP-filtered unemployment used to estimate NAIRU; starting in 2011, contribution of labor to potential growth assumed to increase consistent with historical recoveries (declining NAIRU during recovery).

### Results: historical consistency and projected potential growth (selected quantitative results)
- Authors’ historical consistency with Bank of Canada estimates:
  - Bank of Canada (2008) estimates 2007 potential growth = 2.6 percent; authors estimate 2.5 percent.
  - Bank of Canada (2002) estimated 2002–03 potential growth at 3 percent; authors estimate 2.9 percent.
  - For 2008, Bank of Canada estimates potential growth 1.7 percent; authors 2.4 percent.
- Estimated potential output growth path (selected values):
  - 1977-94: Potential Growth, percentage change 2.6
  - 1995-99: 3.2
  - 2000-04: 3.1
  - 2005-08: 2.6
  - 2008: 2.4
  - 2009: 1.5
  - 2010: 1.5
  - 2011: 1.7
  - 2014: 2.0
  - Average potential growth rate for 2009–14 = 1¾ percent, around 0.3 percentage points below estimates absent the crisis.
- Component series (selected entries as provided)
  - Capital Services, percentage change (sequence): 5.0 5.3 4.3 3.5 4.1 2.2 1.8 2.1 2.4 2.8 3.2
  - Stock of Capital, percentage change (sequence): 4.9 4.9 4.4 4.3 4.1 2.3 1.9 2.0 2.3 2.6 3.1
  - Capacity Utilization, percentage points (levels): 81.7 83.7 84.3 82.4 81.5 81.4 81.3 81.4 81.5 81.6 81.7
  - Labor Services, percentage change (sequence): 1.5 1.5 1.7 1.4 1.3 0.7 0.9 1.1 1.0 1.0 0.9
  - NAIRU, percentage points (levels): 9.4 8.9 7.5 6.4 6.0 6.3 6.4 6.3 6.2 6.1 6.1
  - Labor force participation rate, percentage points (levels): 73.5 75.7 76.9 77.9 78.1 78.2 78.2 78.3 78.3 78.3 78.3
  - Annual hours worked per employee, percentage change (trend): -0.2 -0.1 -0.2 -0.2 -0.2 -0.2 -0.1 0.0 -0.1 0.0 0.0
  - Working age population, percentage change (16-65 years): 1.3 1.2 1.2 1.1 1.1 1.0 1.0 1.0 1.0 0.9 0.9
  - Total Factor Productivity, percentage change: -0.2 0.3 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2
- Losses in potential output
  - By 2014, potential output expected to be about 2.4 percent below the counterfactual level produced by assuming a gradual decline of potential GDP from 2.4 percent in 2008 to 2 percent in 2014.
  - This gap aligns with Furceri and Mourougane (2009) but is lower than Cerra and Saxena (2008) interval of 4 to 16 percent permanent output loss.
  - Note: loss would be around 5 percent assuming potential output grows from 2009 to 2014 at same average rate observed in 2005–08.

### Cross-country pattern and comparisons
- Canada’s potential growth closely mimics U.S. performance, reflecting close real and financial ties and similar industrial/economic structure.
- The current crisis exacerbates the last decade’s downward trend in potential growth rates: "1.4 percentage points lower in the United States" and "around 1.3 percentage points lower in Canada."
- U.S. potential growth, historically above Canada’s, reversed in the 2000s and is projected to remain below Canada over the medium-term due to larger negative implications for the U.S. economy from the crisis.
- Output-gap implication: authors estimate "a much higher output gap for 2009 (at around 5 percent of potential)" versus "a 4 percent" output gap estimated by the Bank of Canada.
- Historical comparisons: the current recession "closely mimics the 1980s in terms of its severity and composition" (private investment declines similar: 13.7 percent in 1982 vs. 13.5 percent projected for 2009).

### Policy implications and recommendations
- Short-run policy stance
  - Canada’s output gap is "still considerably large", implying that "the current accommodating stance for monetary and fiscal policies should stay in place."
- Medium- to long-run policy focus (to raise potential growth)
  - Enabling private R&D investment.
  - Facilitating internal trade.
  - Reducing foreign ownership barriers where possible (including "telecommunications, airlines and broadcasting").
  - Removing obstacles that hinder elderly labor force participation.
  - Ensuring incentives do not hinder firms from growing larger.
- Institutional strengths and ongoing reforms
  - Canada’s "strong macroeconomic and financial stability frameworks" have "enabled Canada to weather the crisis better than most" and will be "pivotal in supporting its recovery."
  - Authorities are "considering or are already implementing" recommendations from Advantage Canada (2006) including "lowering corporate income taxation (at the provincial and federal level) and eliminating capital taxes" and are "considering (and are expected to act promptly on) the recommendations of the Competition Policy Review Panel (2008) to enhance competition and productivity."

### Data sources, measurement and methodological annex (selected points)
- Output: total-economy real Fisher chained GDP from Statistics Canada; trend series obtained by Hodrick-Prescott filter (λ = 100).
- Capital Services: obtained by multiplying trend capital stock by trend capacity utilization. Trend capital stock from OECD Economic Outlook No 85 (annual data). Capacity utilization data from Statistics Canada starting 1988; pre-1988 capacity utilization estimated using growth rates for SIC: Nonfarm Goods-Producing Industries (SA).
- Labor Services: obtained by multiplying (1-NAIRU) by trend labor force participation rate, trend average annual hours worked per employee and trend working-age population. Data from Statistics Canada’s Labor Force Survey.
- Trend TFP: trend TFP level is estimated by applying an HP filter to raw TFP level as estimated in equation (1).
- Assumptions reiterated:
  - Output-labor elasticity = 0.6; output-capital elasticity = 0.4.
  - Working-age population refers to ages "16-65 years of age." Projections as published by Stats Canada.

*Italic: Source — extracted content from the IMF chapter "1. Path for Potential Output Growth Components" (provided content).*

### 1. Path for Potential Output Growth Components ...................................................................26

### 1. Path for Potential Output Growth Components

### Introduction — context and headline projections
- Potential output (the notional amount that could be produced using all available resources without strains on their price) is central to assessing economic slack and timing of exit strategies from policy stimulus.
- Uncertainty around potential output is elevated amid the financial crisis because determinants (capital accumulation, equilibrium unemployment rates, and total factor productivity (TFP)) are affected by severe financial shocks and sectoral reallocation.
- Key projected impacts for Canada amid the crisis:
  - Potential GDP growth would decline significantly in the coming years amid the crisis (by almost 1 percentage point).
  - Potential GDP growth would gradually rise to around 2 percent by 2014 (below the estimated 2.4 percent potential growth for 2008).
  - Potential GDP level would suffer a permanent decline of about 2½ percent vis-à-vis a no-crisis scenario.

- Recent observed movements influencing potential:
  - Investment is down almost 15 percent since end-2008Q2.
  - The protracted recession and tighter financial conditions have already hurt investment and capital accumulation, while higher unemployment will affect equilibrium unemployment rates.

### Theoretical considerations — channels through which the crisis can affect potential output
- Labor input:
  - Ambiguous net short-term effect: recession could reduce labor participation and migration (lower potential labor), but depleted household savings could encourage longer working lives or induce secondary earners to enter the labor market.
  - Expectation of a temporary increase in NAIRU (structural unemployment) from the crisis via hysteresis effects.
  - Labor market flexibility in Canada suggests effects on NAIRU and participation may be temporary and not affect medium-term trends.
  - Demographics will contribute negatively to potential growth beyond the crisis.
- Capital accumulation:
  - Financial crises lower incentives to invest by decreasing sales and raising uncertainty over returns and risk premia.
  - Credit supply is generally lower during a financial crisis as financial institutions repair balance sheets.
  - Canada experienced a large drop in investment since mid-2008, implying slower growth in the capital stock and potential growth.
  - Longer-term investment effects depend on persistence of high capital costs and investor risk attitudes.
- Total factor productivity (TFP):
  - Effect is uncertain a priori:
    - Negative channel: uncertainty and higher capital costs deter private R&D and innovation; Canada’s R&D and innovation already low by international comparisons (OECD, 2006).
    - Positive channel: firms may undertake reforms and restructuring to improve efficiency.
  - Industry heterogeneity matters: financial shocks can lower TFP growth through distorted factor allocation when lending standards tighten (Estevão and Severo, 2009).
  - Empirical evidence for 1990–2007 (31 industries, US and Canada) shows financial shocks tended to lower TFP growth.

### Impact of past financial crises on potential output — empirical evidence
- Cross-country estimates:
  - Furceri and Mourougane (2009): financial crises negatively and permanently affect potential GDP; on average past crises lowered potential GDP level permanently by 1.5–2.4 percent (with some countries seeing declines as much as 4 percent); magnitude increases with severity.
  - Haugh et al. (2009): mixed effects from crises on potential output (events-study approach).
  - European Commission (2009): each year of a banking crisis (average length 3.9 years) is associated with a drop in potential GDP per capita growth of around 0.5 percentage point, with partial restoration during recovery but permanent loss in potential GDP level.
  - Cerra and Saxena (2008): estimate permanent output loss of 4 to 16 percent following financial crises in developed and less developed countries.
- Output losses and recovery:
  - Reinhart and Rogoff (2009): financial crises accompanied by recessions with large losses in output and employment that last longer than “typical” episodes by an average of one year.
  - Haugh et al. (2009): output losses during financial crises are typically two to three times greater than during “normal recessions,” with more protracted recoveries.
- Canadian historical experience:
  - Past financial downturns had severe and long-lasting effects on Canadian output.
  - 1980s recession: contribution of Finance, Insurance, and Real Estate (FIRE) to Canadian GDP growth was negative.
  - 1991 recession: FIRE growth rate decelerated from 3.8 percent in 1990–91 to 2.5 percent in 1992.
  - Onset of the current crisis: FIRE’s growth rate decelerated significantly but did not turn negative, averaging around 1 percent for the last year.

### Productivity developments in the Canadian business sector — stylized facts and sectoral patterns
- Long-run and recent labor productivity trends:
  - Over the past 50 years, productivity in Canada has increased by around 2 percent per year, compared with 2.3 percent in the United States.
  - From 2000 to 2008, labor productivity in Canada's business sector increased at an annual average rate of 0.7 percent versus 2.6 percent in the United States.
  - Between 1961 and 1980, labor productivity in Canada increased 2.9 percent a year on average, faster than the rate of 2.5 percent in the United States.
  - Between 1997–2000, Canadian labor productivity grew by 3.2 percent before decelerating to 1.1 percent and declining by 1 percent in 2008.
- TFP dynamics:
  - Baldwin and Gu (2009): recent slowdown in labor productivity largely explained by slower TFP growth.
  - Canadian TFP average growth:
    - 1980–2000: grew by an annual average of 0.3 percent.
    - 2000–08: declined by 0.6 percent.
  - United States TFP (1996–2006) at 1.5 percent a year versus Canadian figure 0.6 percent a year (Statistics Canada 2007a).
  - Baldwin and Gu estimate the average annual growth rate of TFP in the United States over 1961–2008 was 0.9 percentage points higher than in Canada.
- Sectoral contributions and shifts:
  - Sectoral explanations for Canada–US gap vary across studies:
    - Cardarelli and Kose (2004): U.S. labor productivity acceleration in services, especially trade and FIRE, explains much of the gap.
    - Baldwin and Gu (2009): recent Canadian slowdown primarily explained by slower performance in mining, oil and gas extraction (accounts for 0.6 percentage point of post-2000 deceleration) and manufacturing (accounts for 0.5 percentage point); FIRE accounts for 0.2 percentage point of deceleration.
    - Rao et al. (2005): multiple factors (ICT-producing industries collapse, cyclical factors, commodity prices, Canadian dollar appreciation) make isolation difficult.
  - Recent sectoral outcomes:
    - The decline in labor productivity in 2008 originates mostly from the goods-producing sector, which contracted by almost 3 percent (driven by construction and manufacturing).
    - Construction rose by over 5 percent through the year ending in the second quarter of 2009.
    - Manufacturing labor productivity decline continued in 2009.
    - Services sector labor productivity: averages -0.2 percent in the last three quarters, with large declines in wholesale trade and FIRE.
    - Overall, Canada’s business labor productivity was unchanged year-on-year at the end of the second quarter of 2009.
  - Structural shifts:
    - Lower financial sector activity affects potential growth directly via lower FIRE output (FIRE contributed about a fourth of aggregate output growth in the last decade) and indirectly via higher capital costs and reduced activity elsewhere.
    - Sectoral restructuring: manufacturing share of real GDP at basic prices fell from around 18 percent in the early 2000s to around 13 percent; mining and oil extraction’s share around 4 to 5 percent.

### Canada’s NAIRU — estimates and recent evolution
- Consensus that NAIRU had been declining up to the beginning of the current crisis.
- Historical estimates and findings:
  - Richardson et al. (2000): NAIRU has been declining steadily in Canada.
  - Rose (1988): NAIRU for Canada at end-1987 about 8 percent, with factors reducing it over the medium term.
  - OECD (1996): NAIRU estimates in the mid-1990s ranged from 9.5 percent to 6.5 percent, with average estimate 7.7 percent.
  - Fortin (2000): lowest sustainable rate of unemployment (LSRU) in Canada declined from the 7.5 to 8 percent range to around 6 percent by 2000.
- Recent labor-market dynamics:
  - Labor market flexibility reflected in the immediate impact of the downturn on unemployment: unemployment rate increased from 6.2 percent in September 2008 to 8.6 percent in October 2008.

### Demographics and population projections relevant for potential
- Stats Canada’s baseline projections:
  - Between 2006 and 2011, working-age population will rise by a cumulative 4.4 percent versus over 13 percent increase in the elderly population.
  - By 2031, the elderly population more than doubles (compared to 2006) while the size of the working-age population only increases by 8 percent.

### Cross-study magnitudes and comparative losses
- Summary of empirical magnitudes from literature:
  - Furceri and Mourougane (2009): average permanent potential GDP level loss 1.5–2.4 percent after financial crises.
  - Cerra and Saxena (2008): permanent output loss 4 to 16 percent.
  - European Commission (2009): each year of a banking crisis associated with drop in potential GDP per capita growth of around 0.5 percentage point; average banking crisis lasts 3.9 years.
  - Reinhart and Rogoff (2009): financial-crisis recessions last longer than typical episodes by an average of one year.
  - Haugh et al. (2009): output losses during financial crises typically two to three times greater than during normal recessions, with protracted recoveries.

_Italic: Source — extracted content from the IMF chapter "1. Path for Potential Output Growth Components" (provided content)._

### 7.5 percent in Canada and around six percent in the United States. To explain the structural

### _wp1013 - 7.5 percent in Canada and around six percent in the United States. To explain the structural

### Unemployment insurance and structural differences between Canada and the United States
- Canada’s unemployment insurance system is more generous than in the United States, offering:
  - a higher benefit replacement rate;
  - more extensive coverage;
  - requiring less prior work than the typical program in the United States.
- Research cited indicates greater generosity of the Canadian system:
  - lowers labor force participation and increases the duration of unemployment in Canada relative to the United States (Sharpe, 2001; Fortin and Fortin, 1999).
- Cross-country evidence (Betcherman, 2000) finds that the generosity of unemployment insurance has been systematically associated with higher levels of unemployment across OECD countries.

### Factors cited for the decline in the NAIRU in the 1990s
- Contributing factors include:
  - the drop in the relative size of the youth labor force;
  - higher average education level of the labor force;
  - deregulation in the domestic economy;
  - free trade and globalization increasing labor and product competitiveness;
  - decline in unemployment insurance generosity (lower benefits and stiffer eligibility criteria).
- Additional potential contributors:
  - increased female labor force participation since the mid-1990s;
  - tax and benefit reforms that increased labor force participation for secondary earners (Tsounta, 2006).
- Caveats:
  - Estimates of the NAIRU are very sensitive to methodological choices and should be interpreted with considerable caution (Setterfield et al., 1992; Staiger et al., 1997).
  - The NAIRU concept overlaps with LSRU but the LSRU is broader (Modigliani and Papademos, 1975; Eckstein and Brinner, 1972; Tobin, 1972; Akerlof, Dickens and Perry, 2000).

### Recent NAIRU movements and crisis effects
- The NAIRU is estimated to have declined further in the 2000s, but the current crisis is expected to raise it temporarily due to human capital depletion.
- Sharpe and Sargent (2000) evidence: decline in unemployment rate below previous NAIRU estimates coupled with low inflation indicates a falling structural rate of unemployment in the 2000s.
- Authors’ HP-filter-based NAIRU estimates:
  - observe a declining trend in the 1990s and 2000s;
  - suggest NAIRU could have fallen to around 6 percent only by 2008 (contrasting with Fortin (2000) estimate of 6 percent in early 2000).
- Forecast dynamics:
  - temporary increase in structural unemployment during the crisis, expected to return to pre-crisis levels over the medium term given Canada’s flexible labor markets.

### Simple framework to decompose and project potential GDP growth
- Potential GDP growth decomposed into changes in:
  - capital stock;
  - equilibrium capital utilization;
  - trend hours of work per employee;
  - equilibrium rate of unemployment (NAIRU);
  - trend labor force participation rate;
  - working-age population;
  - trend TFP.
- TFP level calculation used:
  - tfp = y - α ks - α ku - (1-α) l     (1)
  - where variables refer to logarithms: y = output, ks = capital stock, ku = capital utilization, l = total labor hours, tfp = total factor productivity.
- Potential output calculation used:
  - y* = α ks + α ku* + (1-α) h* + (1-α) (1-u*) + (1-α) lfp* + (1-α) wap + tfp*     (2)
  - where h = average hours of work, u = unemployment rate, lfp = labor force participation rate, wap = working-age population.
- Trend values obtained using an HP filter with smoothness parameter λ = 100.
- Parameter choices and data:
  - average share of labor compensation in value added as proxy for (1-α) = 0.62;
  - Sharpe and Arsenault (2009) state labor share in Canada hovers around 0.6 percent with capital share around 0.4;
  - capital data from OECD Economic Outlook; labor data from Statistics Canada’s Labor Force Survey.
- Methodological notes:
  - growth rates constructed from level data;
  - possible extensions include different filtering techniques or longer series (Ravn and Uhlig, 2002).

### Historical trends feeding the decomposition
- Pre-crisis trends identified:
  - growth in working-age population and hours worked per employee had been declining;
  - NAIRU was falling;
  - participation rate was rising after 1990s reforms to employment insurance and tax/benefit systems.
- Filtered TFP growth:
  - does not show large variations but captures post-1990s increase;
  - Statistics Canada (2007) reports average annual TFP growth in Canada rose by 0.6 percent per year between 1997–2007.
- Authors’ TFP findings:
  - TFP increased by an average of 0.4 percent per year for 1997–2007;
  - find TFP hovers around 0.4 percent throughout 1997–2007, differing from Statistics Canada’s split finding (2 percent per year in 1997–2000, then -0.2 percent per year since 2000).
  - longer-run: TFP stalled in the 1980s, contracting by an annual average of -0.1 percent in 1977–1988.

### Assumptions and projections for the crisis and medium term
- Key assumptions influencing potential growth outlook:
  - October 2009 WEO forecast: gross private fixed investment declining by 13.5 percent in 2009 (noted similarity to 13.7 decline in 1982 recession); by mid-2009 investment was 14.8 percent lower than a year ago.
  - For 2010: gross private fixed investment expected to remain at 2009 levels.
  - Investment returns slowly to near pre-crisis ratios to output by end of forecast horizon at around 17.3 percent of nominal GDP.
  - historical rate of depreciation around 8 percent a year used in perpetual inventory method.
  - Canadian firms raise around 25 percent of their capital from U.S. sources (IMF, 2008).
  - Equilibrium capacity utilization in non-farm goods-producing industries assumed essentially constant for the forecast period.
  - Labor force participation assumed essentially unchanged over medium term (negligible rise possible).
  - Growth in working-age population (age 16–65) set to decline slowly per Statistics Canada baseline projections.
  - Average hours of work assumed to continue long-term downward trend.
  - Trend aggregate TFP growth relatively smooth, rising by around 0.4 percent per year in the last decade; assume essentially unchanged through the crisis with minor decline over medium term.
- NAIRU path:
  - fitted HP-filter to Canadian unemployment rates to estimate NAIRU;
  - starting in 2011, increase in contribution of labor to potential growth consistent with historical recoveries (declining NAIRU during recovery).

### Results: historical consistency and projected potential growth
- Historical comparisons:
  - Bank of Canada (2008) estimates 2007 potential growth = 2.6 percent; authors estimate 2.5 percent.
  - Bank of Canada (2002) estimated 2002–03 potential growth at 3 percent; authors estimate 2.9 percent.
  - Bank of Canada (2005) indicates declining trend: potential GDP declined from around 4 percent in 1999 (authors 3.8) to about 2.5 percent (authors 2.9) in 2002.
  - For 2008, Bank of Canada estimates potential growth 1.7 percent (authors 2.4 percent).
- Estimated potential output growth for next five years:
  - lies between 1.5 and 2 percent.
  - after crisis, potential growth converges slowly towards 2 percent in 2014—below pre-crisis average.
  - average potential growth rate for 2009–14 = 1¾ percent, around 0.3 percentage points below estimates absent the crisis.
- Output and unemployment gaps:
  - output gap reaches widest point in 2009 at similar levels as in 1982 recession;
  - unemployment gap peaks in 2010, given unemployment dynamics lags.
- Losses in potential output:
  - by 2014, potential output expected to be about 2.4 percent below the counterfactual level produced by assuming a gradual decline of potential GDP from 2.4 percent in 2008 to 2 percent in 2014 (IMF pre-crisis assumption).
  - this gap aligns with losses observed after previous financial crises (Furceri and Mourougane, 2009) but is lower than Cerra and Saxena (2008) interval of 4 to 16 percent permanent output loss.
  - note: loss would be around 5 percent assuming potential output grows from 2009 to 2014 at same average rate observed in 2005–08.

### Cross-country pattern and comparisons
- Canada’s potential growth closely mimics U.S. performance, possibly reflecting close real and financial ties and similar industrial/economic structure.
- European Commission (2009) findings:
  - potential growth rates in United States and EU-12 have generally trended downwards since late 1980s, with a mid-1990s U.S. pause driven by ICT upsurge lasting until 2000.
- Relative 2008 levels:
  - potential growth rates in 2008 in EU-12, United States and Canada were substantially lower compared with year 2000 (1 percentage point lower in EU-12 countries, United States and Canada as indicated in the analysis).

*Italic: Authors' calculations; sources include OECD; Statistics Canada; Haver Analytics; WEO; Bank of Canada; cited studies in the text.*

### 1.4 percentage points lower in the

### _wp1013 - 1.4 percentage points lower in the

### Potential GDP projections and recent changes
- The current crisis exacerbates the last decade’s downward trend in all countries’ potential growth rates (U.S.: "1.4 percentage points lower in the United States"; Canada: "around 1.3 percentage points lower in Canada").
- U.S. potential growth, historically above Canada’s, reversed in the 2000s and is projected to remain below Canada over the medium-term due to larger negative implications for the U.S. economy from the crisis.
- Immediate impact of the crisis on Canadian potential GDP growth could be severe—"falling by almost 1 percentage point."
- Medium-term outlook: Canadian potential growth is expected to "gradually rise to around 2 percent"—"only a bit lower than its 2008 rate" with the decline mostly reflecting population aging and continuing decline in working hours.
- Output-gap implication: given a high potential GDP growth for 2008, the authors estimate "a much higher output gap for 2009 (at around 5 percent of potential)" versus "a 4 percent" output gap estimated by the Bank of Canada.

### Comparison with other estimates
- Authors’ potential GDP growth projections are "broadly in line" with other researchers.
- NAIRU forecasts show "some minor differences" compared to the OECD, but the shape of potential growth estimates is essentially the same for 2009 and 2010.
- Bank of Canada (2009) numbers are "only 30 basis points lower than ours for 2009, and the same for 2010" (main difference lies in estimates for potential output in 2008).
- Over the medium term, authors share the Bank of Canada’s outlook "at around 2 percent", though with "a more gradual recovery in growth rates" than expected by the Bank.
- Projections also "broadly in line" with Bishop and Burleton (2009).

### Historical comparisons: Past Canadian recessions and the current downturn
- The current recession "closely mimics the 1980s in terms of its severity and composition."
- In the 1982 recession, private investment fell by "13.7 percent"; similar declines are expected for 2009 ("Private Investment ... -13.5" in the table for 2009 projection).
- In 1982 the deceleration in capital stock accumulation removed "more than 1 percentage point from Canada’s estimated potential growth."
- During the 1980s and 1990s recessions, "labor services and TFP contributions were essentially unchanged."
- For the current recession, the adjustment in potential growth is explained "roughly equally by lower contributions of both labor and capital services."
- The projected increase in the NAIRU is "about 0.4 percentage points by the end of 2010", lying "between the larger increase in the early 1980s and unchanged levels in the early 1990s"; this has a "significant impact on potential GDP growth" and is "subject to large uncertainty."

### Quantified paths and component contributions (selected figures preserved)
- Authors’ projected potential growth path (selected values by period):
  - 1977-94: "Potential Growth, percentage change 2.6"
  - 1995-99: "3.2"
  - 2000-04: "3.1"
  - 2005-08: "2.6"
  - 2008: "2.4"
  - 2009: "1.5"
  - 2010: "1.5"
  - 2011: "1.7"
  - 2014: "2.0"
- Components (selected series and contributions as given):
  - Capital Services, percentage change (1977-94 to 2014): "5.0 5.3 4.3 3.5 4.1 2.2 1.8 2.1 2.4 2.8 3.2"
  - Stock of Capital, percentage change (1977-94 to 2014): "4.9 4.9 4.4 4.3 4.1 2.3 1.9 2.0 2.3 2.6 3.1"
  - Capacity Utilization, percentage points (levels): "81.7 83.7 84.3 82.4 81.5 81.4 81.3 81.4 81.5 81.6 81.7"
  - Labor Services, percentage change (1977-94 to 2014): "1.5 1.5 1.7 1.4 1.3 0.7 0.9 1.1 1.0 1.0 0.9"
  - NAIRU, percentage points (levels): "9.4 8.9 7.5 6.4 6.0 6.3 6.4 6.3 6.2 6.1 6.1"
  - Labor force participation rate, percentage points (levels): "73.5 75.7 76.9 77.9 78.1 78.2 78.2 78.3 78.3 78.3 78.3"
  - Annual hours worked per employee, percentage change (trend): "-0.2 -0.1 -0.2 -0.2 -0.2 -0.2 -0.1 0.0 -0.1 0.0 0.0"
  - Working age population, percentage change (16-65 years): "1.3 1.2 1.2 1.1 1.1 1.0 1.0 1.0 1.0 0.9 0.9"
  - Total Factor Productivity, percentage change: "-0.2 0.3 0.4 0.3 0.3 0.3 0.3 0.2 0.2 0.2 0.2

- Table 2 (recent downturns) selected series:
  - Potential Growth, percentage change (1981 to 2014 sequence): "3.7 2.6 2.1 2.6 2.5 2.2 2.0 2.4 2.4 1.5 1.5 1.8"
  - Capital Services, percentage change (1981 to 2014 sequence): "7.4 4.4 3.2 4.7 5.4 4.6 4.0 4.2 3.2 2.2 1.8 2.6"
  - Stock of Capital, percentage change (1981 to 2014 sequence): "7.5 4.4 3.0 4.4 5.4 4.6 3.9 3.9 4.1 2.3 1.9 2.5"
  - NAIRU, percentage points (levels): "9.1 9.4 9.7 9.8 9.8 9.8 9.8 9.8 9.5 8.0 6.3 6.4 6.2" (as shown in the table layout)

### Policy implications and recommendations
- Short-run policy stance:
  - Data suggest Canada’s output gap is "still considerably large", implying that "the current accommodating stance for monetary and fiscal policies should stay in place."
- Medium- to long-run policy focus (to raise potential growth):
  - Enabling private R&D investment (noting private R&D investment is "low in Canada in international comparisons").
  - Facilitating internal trade.
  - Reducing foreign ownership barriers where possible (including "telecommunications, airlines and broadcasting").
  - Removing obstacles that hinder elderly labor force participation.
  - Ensuring incentives do not hinder firms from growing larger.
- Institutional and policy strengths:
  - Canada’s "strong macroeconomic and financial stability frameworks" have "enabled Canada to weather the crisis better than most" and will be "pivotal in supporting its recovery."
  - Authorities are "considering or are already implementing" recommendations from Advantage Canada (2006) including "lowering corporate income taxation (at the provincial and federal level) and eliminating capital taxes" and are "considering (and are expected to act promptly on) the recommendations of the Competition Policy Review Panel (2008) to enhance competition and productivity."

### Annex: Data sources and measurement
- Output: total-economy real Fisher chained GDP from Statistics Canada; trend series obtained by Hodrick-Prescott filter.
- Capital Services: "obtained by multiplying trend capital stock by trend capacity utilization." Trend capital stock from OECD Economic Outlook No 85 (annual data). Capacity utilization: data from Statistics Canada starting 1988; pre-1988 capacity utilization estimated using growth rates for SIC: Nonfarm Goods-Producing Industries (SA).
- Labor Services: "obtained by multiplying (1-NAIRU) by trend labor force participation rate, trend average annual hours worked per employee and trend working-age population." Data from Statistics Canada’s Labor Force Survey. NAIRU defined as trend unemployment rate (both sexes, 15 to 64 Years); labor force participation rate equals labor force (both sexes, 15 to 64 Years) divided by working-age population (both sexes, aged 15 to 64 Years); average annual hours worked per employee constructed by "multiplying actual hours worked per week (all sectors) by 52 and dividing it by total employment (both sexes, 15 years and over)."
- Trend TFP: "Trend TFP level is estimated by applying an HP filter to raw TFP level as estimated in equation (1)."
- Assumptions and methodological notes:
  - "Output-labor elasticity assumed to be 0.6 and output-capital elasticity assumed to be 0.4."
  - Trend capacity utilization calculated using data from Stats Canada (detrended by HP-filter).
  - NAIRU: HP filter of civilian unemployment rate, 15-64 years (seasonally adjusted).
  - Trend labor force participation rate calculated by HP filter of the ratio between labor force and working-age population.
  - Trend changes in annual hours worked per employee calculated by applying the HP filter to annual hours worked per employee in the total economy.
  - Working-age population refers to Canadian population "16-65 years of age." Projections as published by Stats Canada.

*Source: IMF staff estimates and text as provided in the content unit.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp1013.pdf_