Canada: Selected Issues

International Monetary Fund

doi:10.5089/9781451806984.002.A002

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Canada: Selected Issues

Author: International Monetary Fund

Publication Date:: 29 Mar 2005

eISBN:: 9781451806984

Language:: English

Keywords:: ISCR; CR; bank; tax rate; monetary policy response; reaction function; inflation shock; net export; free trade trade agreement; Inflation; Exchange rates; Exchange rate pass-through; Real exchange rates

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This Selected Issues paper for Canada presents comprehensive and broad-based analysis of the role of domestic and external shocks. Canada’s economic history illustrates the important role played by external as well as domestic macroeconomic disturbances. Canada’s economy slowed in 2001 because of the global slowdown, although by less than in many other countries. In 2003, the recovery has been interrupted by a series of shocks that moderated growth. Fluctuations in Canadian real GDP are explained by external and domestic cycles.

Abstract

II. The Effects of U.S. Shocks on the Canadian Economy: Results From a Two-Country Model¹⁷

A. Introduction and Summary

1. The close integration of the Canadian and U.S. economies means that U.S. shocks are quickly transmitted across the border. Canada’s exports to the United States account for about 85 percent of total Canadian exports and about 35 percent of its GDP, and investment flows and financial market ties are also closely linked. As documented by Kose (2004), the increased trade and financial linkages that resulted from the 1989 Canada-U.S. free trade agreement have significantly increased the Canada’s vulnerability to U.S. shocks also impact of the U.S. business cycle on Canada, but stems from its relatively small size and the importance of its natural resource sector.¹⁸

2. The recent strength of the Canadian dollar has intensified interest in the impact of U.S. shocks on the Canadian economy and monetary policy. The vigor of Canada’s net exports during the past year has been surprising, given the 30 percent appreciation of the Canada/U.S. dollar exchange rate since early 2003 (Figure 1). Competing explanations for the modest impact on trade have been offered, including that it has reflected an increase in the flexibility and efficiency of Canadian industry, a decline in exchange rate pass-through, or delays ain the usual adjustment process.

3. These issues are explored here using a small two-country macroeconomic model. In particular, the model is used to investigate how changes in the exchange rate pass-through impact on the transmission of an exchange rate shock on the real economy. The results offer two key insights:

The Canadian economy responds significantly to U.S. macroeconomic and policy shocks, as well as to exchange rate shocks. However, there is considerable scope for monetary policy to respond to ameliorate the effects of these shocks.
The strength of net exports in 2004 appears to be at least partially related to adecline in the pass-through coefficient. The weakening of pass-through—if it is sustained—would significantly reduce the impact of exchange rate shocks on both GDP and inflation.

B. Model Description

4. The model employed for this study is a two-country version of a small open economy model.¹⁹ Each economy is characterized by three equations—an IS curve, an expectation-augmented Phillips curve, and a monetary policy reaction function. Canada is assumed to face both domestic and external shocks (i.e., from the United States), while the United States is assumed to be large enough to be essentially treated as a closed economy. The model allows U.S. output shocks to feed into the Canadian IS equation, while real exchange rate shocks affect both the IS equation and the Phillips curve. For the sake of simplicity, the effects of fiscal policy are not modeled. For Canada, the equations are:

IS curve

$\begin{matrix} {y g a p}_{t} = β_{lead} {y g a p}_{t + 1} + β_{l a g} {y g a p}_{t - 1} - β_{R R} (R R_{t - 1} - R {R^{*}}_{t - 1}) + β_{z g a p} {Z g a p}_{t - 1} + β_{U S} {y g a p}^{U S}_{t} + {u^{y g a p}}_{t} (1) \end{matrix}$

where ygap is the Canadian output gap; RR the Canadian real short-term interest rate; RR* the equilibrium real interest rate for Canada; and ygap^us the U.S. output gap; z_t is the Canadian/U.S. dollar exchange rate, in real terms; z^*_t is the equilibrium real exchange rate; and zgap_t = z_t – z^*_t is the exchange rate gap.
Phillips curve

$\begin{matrix} π_{t} = α_{l e a d} {π^{4}}_{t + 4} + (1 - α_{l e ad}) π_{t - 1}^{4} {+ α_{ygap} ygap}_{t - 1} + α_{z} (z_{t} - z_{t - 1}) + {u^{π}}_{t} & (2) \end{matrix}$

where π is the annualized quarterly inflation rate; and π⁴ is the four-quarter inflation rate.²⁰
Monetary policy reaction function

$\begin{matrix} R S_{t} = {γ^{R S}}_{l a g} {R S}_{t - 1} + (1 - {γ^{R S}}_{l a g}) [{R R}^{*}_{t} + {π^{4}}_{t} + γ_{π} ({π^{4}}_{t + 4} + {π^{*}}_{t + 1}) + γ_{g a p} {y g a p}_{t}] + {u^{R S}}_{t} & (3) \end{matrix}$

where RS is the target for the nominal overnight rate, i.e., the Canadian monetary policy rate. The terms u ^ygap, u^π, and u^RS_t are error terms. This is equivalent to assuming that the Bank allows the real short-term interest rate to deviate from its “equilibrium” level depending on whether the inflation rate that is expected to prevail four quarters ahead deviates from the target, π^*, or whether output deviates from potential. Interest rate smoothing is permitted, however—i.e., the short-term interest rate is set with reference to its value last period.
Real exchange rate (uncovered interest rate parity)

$\begin{matrix} z_{t} + {z^{e}}_{t + 1} - ({R R}_{t} - {R R}^{U S}_{t} - {ρ^{*}}_{t}) / 400 + {ϵ^{z}}_{t} & (4) \end{matrix}$

where ρ^*_t is an interest rate premium. Exchange rate expectations are assumed to follow an autoregressive process: Z^e_{t+ 1} = δ_z Z_{t+ 1} + (1-δ_Z)Z_t-1.

5. Similar equations are assumed for the U.S. economy. However, since the U.S. economy is assumed not to be affected by Canadian shocks, the U.S. IS curve includes neither the foreign output gap nor the Canada/U.S. exchange rate. Moreover, the U.S. Phillips curve does not include the exchange rate.

C. Data and Estimation

6. The model is computationally tractable and provides for a close integration with theIMF’s medium-term forecasting framework. Owing to its simplicity, the model can be easily applied to medium-term economic forecasts provided for the Fund’s World Economic Outlook, for example, to consider the effects of different policy responses or the validity of model assumptions.²¹ It also facilitates the application of sophisticated estimation and simulation techniques that have been developed in recent years.

7. The model employs Bayesian estimation techniques. This approach incorporates prior knowledge about parameter values, which is especially useful given the short data sample. It also provides information on distribution of model parameters and shocks. All shocks are modeled as first-order autoregressive processes with normally distributed error terms, with the sole exception of the exchange rate shock, which is assumed to be normally distributed. In addition, all data are assumed to include some parameterized measurement error to account for data uncertainty related to the possibility of future revisions.

8. The model uses quarterly data from 1996 through the third quarter of 2004. The sample period was chosen to exclude transition effects from Canada’s adoption of an inflation target in 1991. The model was first estimated using historical data, and then simulated over the forecast horizon. The equilibrium values of variables (i.e., the starred variables) were determined using a version of the Hodrick-Prescott filter (except for the Canadian inflation target, which is set at 2 percent).

D. Results

9. The simulation results indicate that real shocks to the U.S. economy significantly affect both Canadian GDP and inflation. The effect of a 1 percentage point increase in U.S. GDP, which stems from a temporary demand shock linked to the IS curve, is to raise Canadian GDP by almost ½ percent and inflation by ⅓ percentage point (Figures 2 and 3). Conversely, a permanent 1 percent reduction in U.S. potential output—which would be equivalent to a negative U.S. supply shock—reduces the level of GDP in Canada by about 1½ percent and inflation by 1 percentage point over six quarters.

10. The model can be used to illustrates the costs of delaying the monetary policy response to external and other shocks. For example, if Canadian monetary policy were assumed to respond with a four-quarter lag (rather than immediately as is implied by the monetary reaction function described above), the impact of the temporary U.S. demand shock would be about ¼ percent larger over 4 quarters, and CPI inflation would be correspondingly higher (Figures 2 and 3). Moreover, the delayed monetary policy response requires a larger interest rate movement—in this case the Bank is required to raise its policy rate by about ½ percentage point more in the quarter of the move than otherwise.

11. The speed of the monetary policy response is also important in determining how U.S. inflation shocks affect the Canadian economy. For example, the impact of a 1 percentage point U.S. inflation shocks—which is modeled as shock to the U.S. Phillips curve—on Canada’s GDP and inflation would be roughly halved by an immediate response from the Bank of Canada versus a delayed response.

12. The model illustrates that U.S. monetary policy has a relatively modest effect on Canada. For example, even if the monetary policy reaction were delayed by four quarters, a 100 basis point increase in the federal funds rate would reduce Canadian GDP by only about 0.1 percent over six quarters (Figure 4). Again, allowing an immediate policy response would halve this (already small) effect, with the impact on Canadian inflation being negligible in both cases.

13. The impact on Canada of exchange rate shocks is relatively strong, however, reflecting its export dependency (Figure 5). Simulation results suggest that a 20 percent real appreciation of the Canadian dollar vis-à-vis the U.S. dollar reduces Canada’s GDP by about 1 percent over four quarters, even if the Bank of Canada were to immediately reduce its target rate by 1½ percent. This effect almost doubles if rate hikes are delayed.

14. However, the model also illustrates that the effect of exchange rate shocks depends significantly on the degree of pass-through (Figure 6). If the pass-through coefficient, β_zgap, in equation (1) is lowered by half, the impact of an exchange rate appreciation on GDP is reduced by about a quarter, and on the rate of inflation by nearly a half. This result is consistent with the view of a number of analysts in Canada that the seemingly modest response of Canadian net exports and growth in 2004 to the strong appreciation of the Canadian dollar over the past 2–3 years is partially accounted for by a decline in exchange rate pass-through.

E. Conclusions

15. Using a simple two-country version of the small open economy model, this paper evaluates impact of the shocks to the U.S. economy on Canada. The results suggest that monetary policy can play an important role in reducing the effect of U.S. and exchange rate shocks on the Canadian economy. They also indicate that the exchange rate pass-through plays a significant role in determining the impact of the exchange rates shocks on Canada.

References

Berg, A., D. Laxton, and P. Karam, 2005, “Monetary Policy Analysis at the IMF: A Practical Guide,” unpublished manuscript (Washington: International Monetary Fund).
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Coats, W., D. Laxton, and D. Rose (eds.), 2003, The Czech National Bank’s Forecasting and Policy Analysis System (Prague: Czech National Bank).
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Kose, A., 2004 “Canada-U.S. Integration: Developments and Prospects,” in Canada: Selected Issues, IMF Country Report No. 04/60 (Washington: International Monetary Fund).
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Lane, P., 2003, “The New Open Economy Macroeconomics: A Survey,” Working Paper No. 3 (Cambridge, U.K.: Trinity College).
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Prepared by Iryna Ivaschenko and Andrew Swiston. The authors are grateful to Douglas Laxton for invaluable help with the model.

In 2003, Canada’s GDP was equivalent to about 8 percent of U.S. GDP, and domestic absorption accounted for 7 percent of that in the United States.

Lane (2003) provides a review of the new open-economy literature. See Berg, et al. (2005) for a description of the model used here.

The results of estimating the model with either core or headline inflation are qualitatively the same.

See Coats and others (2003) and references therein.

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