The Impact of Labour Force Participation on Unemployment Rate Fluctuations in Canada

Abstract

This paper studies cyclical fluctuations in the Canadian unemployment rate using a three-state framework of employment, unemployment and nonparticipation. First, by using a flow-based variance decomposition, I find that transitions between nonparticipation and unemployment can explain around 35% of the change in the Canadian unemployment rate between 1976 and 2019. For comparison, these transitions account for 33% of the change in the American unemployment rate between 1978 and 2012. However, in Canada, nonparticipation to unemployment transitions play a much larger role (21% vs 13%). Additionally, my findings support the conclusions of past papers that a stock-based decomposition of the unemployment rate is subject to the stock flow fallacy. Since over 90 percent of transitions from one labour market state to another gets offset by simultaneous transitions in the opposite direction, a decomposition cannot distinguish between the different patterns of worker flows that result drive cycles in the participation rate. Finally, by comparing the Canadian and American labour markets, I show that during recessions, the percentage of the unemployment population in Canada that belong to each demographic, including categories of age, sex, education level and an individual’s reason for unemployment, does not change as substantially as in the United States. This is due to the Canadian labour market being less dynamic.