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

In an era when the primary policy instrument is the level of the short-term interest rate, a comparison of that rate with some equilibrium rate 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. The authors estimate equilibrium interest rates for Canada using a sticky-price dynamic stochastic generalequilibrium model. They follow closely the methodology of Neiss and Nelson (2003) and derive measures of the interest rate gap for Canada. Their results indicate that the interest rate gap can be a useful guide for policy and is a good indicator of future output and inflation. The authors also find that their measures of the interest rate gap perform as well as the yield spread, a typical measure of policy stance that is assumed to contain significant information about future economic activity.

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Paper provided by Bank of Canada in its series Staff Working Papers with number 04-9.

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Length: 48 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:bca:bocawp:04-9
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Fax: 613 782-8874
Web page: http://www.bank-banque-canada.ca/

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  7. Katharine S. Neiss and Edward Nelson, 2001. "The Real Interest Rate Gap as an Inflation Indicator," Computing in Economics and Finance 2001 145, Society for Computational Economics.
  8. 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.
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  18. 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.
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