The effects of the U.S. business cycle on the Canadian economy: A regime-switching VAR approach

This study assumes a large-closed and small-open economy relationship between the United States and Canadian economies using a seemingly unrelated regression (SUR) system of equations, where the U.S. economy is treated as being an exogenous block and the Canadian economy as the endogenous block. The model is extended to a regime-switching framework to evaluate asymmetries in the systematic responses of the Canadian economy to movements in the business cycle in the U.S. The estimation results suggest that initially over 75 per cent of an innovation in the U.S. output gap is propagated to output in Canada in the high-variance regime and over 55 per cent in the low-variance regime. Nevertheless, the response of the Canadian output gap remains proportional (at about two thirds) to the innovations in the U.S. output gap in both regimes. Over 50 per cent of the covariance between the impulse responses for the output gaps in both countries can be attributed to the U.S. shock in both regimes. However, the response of the output gap in the Canadian economy is much more persistent and stable in the current low-variance regime. Long-run static multipliers for the Canadian output gap suggest that the effects of disturbances in the U.S. business cycle are more than twice as large in the current macroeconomic regime.