The Monetary Transmission Mechanism in Canada: A Time-Varying Vector Autoregression with Stochastic Volatility

Abstract

This study uses the state-space representation of a time-varying vector autoregression with stochastic volatility (TVP-VAR-SV) to study monetary policy and private sector behaviour in Canada. The main results indicate that both shock variances and autoregressive coefficients of the VAR have evolved systematically over time. The time-varying coefficients of the systematic component of the VAR suggest that monetary policy has become more proactive and less reactive regarding inflation since the early-1990s, which coincides with the adoption of explicit inflation targets. Monetary policy is now able to focus mainly on movements in the output gap to prevent future increases in inflation. The coefficients on the policy rate in both the output gap and inflation equations suggest that the private sector and therefore the transmission mechanism have become more sensitive to monetary policy responses. On the other hand, the coefficients on the output gap in the equations for both inflation and the policy rate have been relatively stable over this period, consistent with view that monetary policy remains more forward-looking regarding inflation than being reactive to inflation surprises as in the past.