Transmission of US monetary policy into the Canadian economy: A structural cointegration analysis

Abstract

This paper estimates a two-country model comprising structural cointegrated models of Canada and the US. Using persistence profile analysis, we find that the Term Structure and a modified Fisher equation are maintained in the US model, and, the Term Structure, Fisher equation and Interest Rate Parity are maintained in the Canadian model. Then we use the model to examine the transmission of US monetary policy into the Canadian economy. The results show that the responses of the Canadian macro variables to the US monetary policy shock are very similar to the responses of the US macro variables to the same shock: after a contractionary US monetary policy shock, output falls quickly and shows a U-shaped response, inflation falls with a delay, short-term interest rate jumps and then gradually declines and long-term interest rate increases for one year and then gradually declines. Our results show that interest rate-path-through is the major mechanism by which US monetary policy shocks are transmitted into the Canadian economy.