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Specification of a Stochastic Simulation Model for the Analysis of Monetary and Fiscal Policy

  • Doug Hostland

This paper documents the specification of a model that was constructed specifically for the purpose of analysing alternative strategies for implementing monetary and fiscal policy in Canada using stochastic simulation methods. Some key features of the model are as follows. The domestic sector of the model is modelled as a small open economy, which is strongly influenced by economic and financial developments in the foreign sector. Expectations play a central role in determining inflation, interest rates and the exchange rate. Expectations are formed as a combination of forward-looking (model-consistent forecasts) and backward-looking (adaptive) components. Economic developments affect fiscal revenues and expenditures in the model, and vice versa, so that fiscal policy actions have economic repercussions. The public debt is comprised of treasury bills and government bonds with maturities that range from one quarter to twenty years. This is a distinctive feature of the model that results in non-trivial dynamics for debt service costs. Monetary and fiscal policy are determined using simple policy rules. The monetary authority reacts to unanticipated economic developments each quarter in an effort to keep inflation within a target range. The fiscal authority plans a budget each year in an effort to keep the debt-to-GDP ratio on a clear, downward profile. The model is designed to compare alternative monetary policy rules and fiscal planning strategies. The parameters in the model are specified using an eclectic methodology that combines estimation and calibration procedures. Some parameters are determined on the basis of estimated reduced-form equations; other parameters are calibrated using the method of simulation moments. The structure of the model is designed to allow for a wide range of alternative parameter values to facilitate sensitivity analysis. Ce document étaye la formulation d’un modèle établi précisément pour analyser diverses stratégies de mise en œuvre des politiques monétaire et fiscale au Canada à l’aide de méthodes de simulation stochastique. Voici certaines des principales caractéristiques du modèle. Le secteur intérieur est modélisé comme une petite économie ouverte, fortement influencée par la conjoncture économique et financière du secteur extérieur. Les attentes jouent un rôle de premier plan dans la détermination de l’inflation, des taux d’intérêt et du taux de change. Les attentes comportent à la fois des éléments prospectifs (prévisions cohérentes du modèle) et rétrospectifs (adaptatifs). La conjoncture économique influe sur les recettes fiscales et les dépenses dans le modèle, et vice versa, de sorte que les mesures fiscales ont des répercussions sur l’économie. La dette publique comprend les bons du Trésor et les obligations gouvernementales venant à échéance dans un trimestre jusqu’à 20 ans. Il s’agit d’une caractéristique distinctive du modèle qui se traduit par une dynamique non négligeable pour les frais de service de la dette. Les politiques monétaire et fiscale sont déterminées grâce à des règles de politique simples. Les autorités monétaires réagissent à l’évolution imprévue de l’économie chaque trimestre afin de maintenir l’inflation à l’intérieur d’une fourchette cible. Les autorités financières planifient un budget chaque année afin de maintenir le ratio de la dette au PIB sur une trajectoire descendante. Le modèle est conçu pour comparer les diverses règles de la politique monétaire et les stratégies de planification financière. Les paramètres du modèle sont précisés à l’aide d’une méthode éclectique réunissant des procédures d’estimation et de calibration. Certains paramètres sont déterminés en fonction d’équations de forme réduite estimatives; d’autres paramètres sont calibrés selon la méthode des moments de simulation. La structure du modèle est conçue afin de permettre à toute une gamme de valeurs de paramètres de faciliter l’analyse de sensibilité.

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Paper provided by Department of Finance Canada in its series Working Papers-Department of Finance Canada with number 2001-14.

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Handle: RePEc:fca:wpfnca:2001-14
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