An Empirical Investigation of the Transmission of Canadian Monetary Policy

Abstract

Introduction The Bank of Canada (BOC) has a particular view of how its monetary policy actions work their way through the economy. This paper is intended to investigate the extent to which empirical evidence matches the BOC's view. Specifically, it uses a vector autoregression (VAR) technique to determine how independent changes in the Bank's bellwether rate are transmitted to other interest rates, the exchange rate, various types of spending, and the consumer price index. Although somewhat similar work has been performed in the past, this is the first that has modeled the early stages of the transmission process so completely, and is the first that has used disaggregated measures of spending. The results for some stages of the process--other interest rates, retail sales, business borrowing, and inventories--are generally consistent with the Bank's view, but the results for other factors--exchange rates, imports, and exports--are less clear. Counterintuitive effects are found for consumer prices, although this practically disappears in an alternative specification. The organization of this article is as follows: The first section describes the theoretical transmission of monetary policy in Canada according to the BOC. Section two describes the VAR technique, and reviews some of the past applications of this technique to the Canadian economy. The next section describes the data and specifications used in the analysis; the following section reports the results of the analysis and provides some discussion. A final section describes possible enhancements to be pursued in future work and is followed by the study's conclusions. The Transmission of Monetary Policy Before undertaking an empirical study of the effect of BOC policy actions, it is useful to review the theoretical effect that monetary policy has on the economy. Briefly, the process is believed to work as follows: The Bank first takes actions that influence the deposits that private banks hold at the BOC, which influences the interest rate that private financial institutions pay to one another for one-day loans. These actions influence market-determined interest and exchange rates, which in turn affect several types of spending in the economy. These changes in spending eventually affect prices at the consumer level. What follows is a somewhat more complete description. For a definitive view of how the process is supposed to work according to the BOC, see Thiessen (1996) and other articles in the same volume. For an even more formal and slightly different explanation, see Duguay (1994). The first stage of the monetary policy transmission process is accomplished when the BOC transfers government deposits between private financial institutions and itself. If the Bank moves deposits out of these accounts, it will create a shortfall in the amounts that private banks hold to facilitate the daily clearing of payments among themselves. Shortfalls are costly to private banks because the BOC charges a relatively high penalty rate of interest when the shortfall occurs. The shortfall can be avoided if the private bank takes out a one-day loan from security dealers. The rate of interest on these loans is commonly called the overnight When the BOC moves deposits out of the accounts of private banks on a widespread basis, most banks will attempt to acquire loans. As they do, the demand for these loans increases and the rate will increase in response. An opposite response occurs when the BOC adds government deposits. Private banks will want to lend balances (because they earn no interest on excess balances), and this will cause a decrease in the rate.(1) Although the rate has little direct effect on the economy, it does have a strong indirect effect through its effect on longer-term interest rates and exchange rates. Medium-term rates of interest will depend a great deal on the expected path of this very short-term rate. …