Canadian Monetary Policy: Lessons from the Crisis

The following is a report from a panel of the same title held at the Rimini Conference in Economics and Finance, Rimini, Italy, 10-13 June 2010, and organized by the Rimini Conference for Economic Analysis (RCEA). Panel Chair: Angelo Melino (University of Toronto and RCEA). Panelists: David Andolfatto (Vice President and Economist, Federal Reserve Bank of St. Louis; Professor of Economics, Simon Fraser University; RCEA), David E.W. Laidler (Professor Emeritus, University of Western Ontario; Fellow-in-Residence, C.D. Howe Institute; FRSC; Honorary Senior Fellow RCEA), John Murray (Deputy Governor, Bank of Canada).

Moving Monetary Policy Forward: Why Small Steps - and a Lower Inflation Target - Make Sense for the Bank of Canada

The current monetary policy agreement between the Bank of Canada and the Department of Finance is set to expire at the end of 2011. Among the policy options under consideration is the adoption of either a lower inflation target or a switch to price-level targeting. The recent financial crisis provided a costly reminder that price stability does not necessarily guarantee financial stability, and the Bank’s post-2011 mandate might include a role for asset market stability. This Commentary offers an overview of the policy options now being contemplated for the renewal of the monetary policy framework in 2011 and addresses some of the more technical issues related to the post-2011 monetary policy framework.Monetary Policy, Bank of Canada, inflation targeting (IT), price-level targeting (PLT)

Duration Dependence and Nonparametric Heterogeneity: A Monte Carlo Study

We examine the behaviour of the nonparametric maximum likelihood estimator (NPMLE) for a discrete duration model with unobserved heterogeneity and unknown duration dependence. We find that a nonparametric specification of either the duration dependence or unobserved heterogeneity, when the other feature of the hazard is known to be absent, leads to estimators that are well behaved even in modestly sized samples. In contrast, there is a large and systematic bias in the parameters of these components when both are specified nonparametrically, as well as a complementary bias in the coefficients on observed heterogeneity. Furthermore, these biases diminish very gradually as sample size increases. We find that a minor modification of the quasilikelihood that penalizes specifications with many points of support leads to a dramatic improvement.Duration model, unobserved heterogeneity, NPMLE

Greater Transparency Needed

Financial market participants would benefit from a better understanding of how the Bank of Canada sets the overnight interest rate in response to economic developments. More accurate forecasts of the Bank’s future policy choices would lead to better financial decisions and better price and wage-setting decisions, making it easier for the Bank to hit its 2 percent inflation target. Currently, the Bank’s internal model predicts a path for the overnight rate that is inconsistent with the expectations of the Bank’s Governing Council. The Bank could achieve greater transparency by publishing its own conditional forecasts of the future path of the overnight rate or, failing that, by publishing such forecasts with a six-month lag. This would enable market participants to better understand what these forecasts mean and how to use them in economic decision-making.Monetary Policy, Bank of Canada, overnight interest rate, inflation target

State Dependent Preferences Can Explain the Equity Premium Puzzle

We introduce state dependent recursive preferences into the Mehra-Prescott economy. We show that such preferences can match the historical first two moments of the returns on equity and the risk free rate. Other authors have reported similar results using state dependent expected utility preferences. These authors have tended to emphasize the importance of countercyclical risk aversion in explaining the equity premium puzzle. We find that countercyclical risk aversion plays an important role but only when combined with modest cyclical variation in intertemporal substitution.

Cyclical Behavior of Prices and Quantities in the Automobile Market

This paper has a simple goal, that of understanding the joint behaviorof prices and quantities in a particular market. More precisely, it examines whether we can find decision problems for suppliers and buyers, together with a market equilibrium structure, which are consistent with the observed price and quantity time series. Because of the relative homogeneity of the product, of the size of the market, end of the quality of the data, the market chosen is the automobile market.The first conclusion we reach is that this goal is difficult to achieve.The behavior of prices appears inconsistent with simple -- competitive, monopolistically competitive or monopolistic -- market structures. Prices appear, in a well defined sense, to be too "sticky". We then consider potentiail explanations and extensions. None appears completely satisfactory. In particular, the introduction of costs of changing prices does not seem able to explain the joint behavior of prices and quantities.

The Term Structure of Interest Rates: Evidence and Theory

The term structure of interest rates is an old topic. Over the years, both the hypotheses debated and the research techniques used have changed considerably. Two fairly recent developments which distinguish current research are the widespread adoption of rational expectations and the integration of the term structure with the general theory of asset pricing. This survey reviews previous work from this perspective. The main objective is to catalog available evidence about term premia and to interpret this evidence in light of alternative models of term premia determination.

The Response of Interest Rates to the Federal Reserve's Weekly Money Announcements: The "Puzzle" of Anticipated Money

Researchers, using the survey conducted by Money Market Services, Inc., have found that the anticipated component in the Federal Reserve's weekly money supply announcement is negatively correlated with the post- announcement change in market yields. We prove that eliminating a (downward) bias in the measure of anticipated money can, in theory, eliminate this puzzle, but that improving the efficiency of an already unbiased measure cannot. We find, using Canadian as well as U.S. interest rate data, that correcting the downward bias in the survey measure reduces, but does not eliminate, the role of anticipated money.

Estimating the Continuous Time Consumption Based Asset Pricing Model

The consumption based asset pricing model predicts that excess yields are determined in a fairly simple way by the market's degree of relative risk aversion and by the pattern of covariances between percapita consumption growth and asset returns. Estimation and testingis complicated by the fact that the model's predictions relate to the instantaneous flow of consumption and point-in-time asset values, but only data on the integral or unit average of the consumption flow is available. In our paper, we show how to estimate the parameters of interest consistently from the available data by maximum likelihood. We estimate the market's degree of relative risk aversion and the instantaneous covariances of asset yields and consumption using six different data sets. We also test the model's overidentifying restrictions.