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Sources of regime switching in short-term interest rates for Canada

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  • Ronald Lange

Abstract

The purpose of this study is to identify sources of regime switching in short-term interest rates for Canada. The choice of information variables is based on three well-known hypotheses about interest rates: the expectations hypothesis, the Fisher relationship, and the condition for uncovered interest parity. The empirical framework consists of an autoregressive distributive lag (ADL) model in error-correction form with information spreads and a Markov regime-switching estimation methodology. The models choose interest-rate regimes that are similar in many respects to those found for the USA. The different regimes in Canada are driven by movements in the monetary policy rate, the US short-term rate, and the long-term yield. The monetary policy rate is found to trigger very large changes in the short-term rate, responding one-for-one in the high-variance regime and slightly less in the more 'normal' interest-rate regime. Both the US short rate and long-term yield are also found to trigger relatively large changes in short-term rates, but only in the high-variance regime. Inflation, however, is not found to contain additional information about regime switches in interest rates at the short-term horizon.

Suggested Citation

  • Ronald Lange, 2010. "Sources of regime switching in short-term interest rates for Canada," Applied Economics, Taylor & Francis Journals, vol. 42(4), pages 439-454.
  • Handle: RePEc:taf:applec:v:42:y:2010:i:4:p:439-454
    DOI: 10.1080/00036840701630078
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    References listed on IDEAS

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    1. Andrew Ang & Geert Bekaert & Min Wei, 2008. "The Term Structure of Real Rates and Expected Inflation," Journal of Finance, American Finance Association, vol. 63(2), pages 797-849, April.
    2. Sarno, Lucio & Thornton, Daniel L. & Valente, Giorgio, 2007. "The Empirical Failure of the Expectations Hypothesis of the Term Structure of Bond Yields," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(1), pages 81-100, March.
    3. Jamie Armour & Walter Engert & Ben Fung, 1996. "Overnight Rate Innovations as a measure of monetary Policy Shocks in Vector Autoregressions," Staff Working Papers 96-4, Bank of Canada.
    4. Ron Lange, 1999. "The Expectations Hypothesis for the Longer End of the Term Structure: Some Evidence for Canada," Staff Working Papers 99-20, Bank of Canada.
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    1. Ronald H. Lange, 2013. "Monetary policy reactions and the exchange rate: a regime-switching structural VAR for Canada," International Review of Applied Economics, Taylor & Francis Journals, vol. 27(5), pages 612-632, September.
    2. Lange, Ronald H., 2010. "Regime-switching monetary policy in Canada," Journal of Macroeconomics, Elsevier, vol. 32(3), pages 782-796, September.

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