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Estimating Policy-Neutral Interest Rates for Canada Using a Dynamic Stochastic General Equilibrium Framework

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Author Info
Jean-Paul Lam
Greg Tkacz

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Abstract

In an era where the primary policy instrument is the level of short-term interest rates, comparing the level of such a rate relative to some equilibrium value can be a useful guide for policy and a convenient method to measure the stance of monetary policy. The real interest rate gap, the difference between the real equilibrium rate and the rate set by the central bank, can thus serve as a leading indicator of future inflationary or deflationary pressures in the economy. This paper estimates equilibrium interest rates for Canada using a sticky-price dynamic stochastic general equilibrium (DSGE) model. We follow the methodology of Neiss and Nelson (2003) closely and derive measures of the interest rate gap for Canada. Our results indicate that the interest rate gap can be a useful guide for policy and is a good an indicator of future output and inflation. Moreover, we find that our measures of the interest rate gap perform as well as the yield spread, a typical measure of policy stance which is assumed to contain significant information about future economic activity.

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Article provided by Swiss Society of Economics and Statistics (SSES) in its journal Swiss Journal of Economics and Statistics.

Volume (Year): 140 (2004)
Issue (Month): I (March)
Pages: 89-126
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Handle: RePEc:ses:arsjes:2004-i-4

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Keywords: Interest rates;

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Find related papers by JEL classification:
C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions
E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Duguay, Pierre, 1994. "Empirical evidence on the strength of the monetary transmission mechanism in Canada: An aggregate approach," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 39-61, February. [Downloadable!] (restricted)
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    Other versions:
  3. Thomas Laubach & John C. Williams, 2001. "Measuring the natural rate of interest," Finance and Economics Discussion Series 2001-56, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  4. Edith Gagnon & Hashmat Khan, 2001. "New Phillips Curve with Alternative Marginal Cost Measures forCanada, the United States, and the Euro Area," Working Papers 01-25, Bank of Canada. [Downloadable!]
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  11. Bennett T. McCallum & Edward Nelson, 2000. "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," NBER Working Papers 5875, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Jeff Fuhrer, 2000. "Optimal Monetary Policy In A Model With Habit Formation," Computing in Economics and Finance 2000 306, Society for Computational Economics.
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  13. Denise Côté & John Kuszczak & Jean-Paul Lam & Ying Liu & Pierre St-Amant, 2004. "The performance and robustness of simple monetary policy rules in models of the Canadian economy," Canadian Journal of Economics, Canadian Economics Association, vol. 37(4), pages 978-998, November. [Downloadable!] (restricted)
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  14. Ireland, Peter N., 1997. "A small, structural, quarterly model for monetary policy evaluation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 83-108, December. [Downloadable!] (restricted)
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  16. Bomfim, Antulio N, 1997. "The Equilibrium Fed Funds Rate and the Indicator Properties of Term-Structure Spreads," Economic Inquiry, Oxford University Press, vol. 35(4), pages 830-46, October.
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  18. Tkacz, Greg, 2001. "Neural network forecasting of Canadian GDP growth," International Journal of Forecasting, Elsevier, vol. 17(1), pages 57-69. [Downloadable!] (restricted)
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  20. White, Halbert, 1980. "A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity," Econometrica, Econometric Society, vol. 48(4), pages 817-38, May. [Downloadable!] (restricted)
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  22. Antulio N. Bomfim, 2001. "Measuring equilibrium real interest rates: what can we learn from yields on indexed bonds?," Finance and Economics Discussion Series 2001-53, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Maria da Glória D. S. Araújo & Mirta Bugarin & Marcelo Kfoury Muinhos & Jose Ricardo C. Silva, 2006. "The Effect of Adverse Supply Shocks on Monetary Policy and Output," Working Papers Series 103, Central Bank of Brazil, Research Department. [Downloadable!]
  2. Juan José Echavarría & Enrique López Enciso & Martha Misas Arango & Juana Tellez Corredor, 2006. "La Tasa de Interés Natural en Colombia," BORRADORES DE ECONOMIA 003088, BANCO DE LA REPÚBLICA. [Downloadable!]
    Other versions:
  3. Roman Horvath, 2007. "The Time-Varying Policy Neutral Rate in Real Time: A Predictor for Future Inflation?," Working Papers 2007/4, Czech National Bank, Research Department. [Downloadable!]
    Other versions:
  4. Mirta Noemi Sataka Bugarin & Marcelo Kfoury Muinhos & Jose Ricardo da Costa e Silva & Maria da Glória D. Silva Araújo, 2005. "The Effect of Adverse Oil Price Shocks on Monetary Policy and Output Using a Dynamic Small Open Economy General Equilibrium Model With Staggered Price for Brazil," Working Papers Central Bank of Chile 348, Central Bank of Chile. [Downloadable!]
  5. Paul Castillo & Carlos Montoro & Vicente Tuesta, 2006. "Measuring the Natural Interest Rate for the Peruvian Economy," Working Papers 2006-003, Banco Central de Reserva del Perú. [Downloadable!]
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