Stagflation and Productivity Decline in Canada, 1974-1982

The MACE model of Canada employs a nested production structure in which there is a vintage bundle of capital and energy that is combined with efficiency units of labour to define potential output for given quantities of employed factors. The actual level of output is derived from an estimated utilization-rate equation, in which the ratio of actual to potential output depends on unexpected sales, profitability, and the gap between actual and desired inventories. Using this production structure, it is possible to attribute 30% of the decline in labour productivity between 1973 and 1982, relative to a steady growth case, to desired substitution of labour for energy, one-third to unexpectedly low demand, and one-fifth to low profitability. The unexplained residual is less than one-fifth. The macroeconomic structure of the model is then used totrace the underlying reasons for the differences between steady growth and actual history. It is concluded that most of the changes in factor proportions, demand, and profitability in Canada were due to the changes in world oil prices and the parallel changes in inflation and real output in other industrial countries.