Close-Embrace : Canada-US Common Trends

This paper studies the joint dynamics of the Canadian economy in conjunction with US economic variables. The methodology employed is that of the structural vector error correction that combines unrestricted short-run dynamics with long- run restrictions derived from growth theory. Common trends, as well as transitory shocks to these two economies are identified. The model economy is then estimated with quarterly data from 1961q1 to 2008q1. Four long-run equilibrium relationships are confirmed with data: i) purchasing power parity, ii) technological differentials, iii) interest rate parity, iv) net foreign assets accumulation. Four common trends or permanent common shocks are identified between the two economies: i) technological, ii) interest rate, iii) price, and iv) exchange rate relations. The model explains that the exchange rate appreciation is consistent with accumulation of foreign assets in Canada, that Canada and US cycles are correlated, and that technological innovation is the main driving force of long-run growth for both economies. The results seem in line with the supply side policies of the Bank of Canada