Are the economies of Canada and the United States integrated? Evidence from co-integration

The decade long US legislation authorizing a federal tax cut, initially signed by President George W. Bush in 2001 and extended by President Barack Obama in 2008 and 2010, had been set to expire on January 1, 2013. The legislation called for over $536 billion in automatic federal tax increases and for over $109 billion in federal spending cuts at the same time. This situation had created both a fiscal dilemma and a heated political debate for the US government. As the debate escalated, the news media named it the fiscal cliff and began reporting a growing public concern about its adverse consequences on the economy. Public concern stemmed from a fear that if the fiscal cliff had not been averted, automatic public spending cuts and tax increases would have produced a 4-5 percent decrease in US gross domestic product (GDP). The fiscal cliff was also a concern internationally. In the modern economic history, the United States is considered the economic superpower, and any dip in the US aggregate demand would have been felt immediately in an interdependent world economy, especially by Canada, its neighbor to the north. It was in this context that the late Canadian Finance Minister, Hon. Jim Flaherty, expressed the concern that any US political gridlock in negotiations between Democrats and Republicans over the fiscal cliff would adversely affect the US economy and very likely drag the Canadian economy into recession. The late Canadian Finance Minister, Hon. Jim Flaherty’s concern was not totally unfounded: a year later the cliff, indeed, culminated in the US government shut down.

From the Canadian perspective, the late Finance Minister Flaherty’s concern about the US fiscal cliff may have been a reflection of the commonly held view that the economies of Canada and the United States are interdependent and integrated. What happens in the South affects Canada in the North. Thus, our objective in this research is to find additional support for the proposition that the economies of Canada and the United States are co-integrated.

While previous research analyzed output (GDP), specific commodity prices, interest rate, stock prices etc. and made predictions about the economic integration between Canada and the United States, none have explored if monetary policy and fiscal policy of Canada and United States are cointegrated. Using time series co-integration analysis, we find statistical support that the economies of Canada and the United States are indeed highly co-integrated.