Stephen Murchison reviews the findings of recent Bank of Canada research on the relative merits of inflation targeting and price-level targeting (PLT) for a small open economy, such as Canada's, that is susceptible to large and persistent terms-of-trade shocks. These shocks have been identified as a potential threat to PLT, since central bankers have to induce large fluctuations in output if they are to unwind all pass-through to the price level. The balance of evidence suggests that PLT and inflation targeting, implemented through simple policy rules, are fairly similar in their ability to stabilize inflation, the output gap, and interest rates. The author shows that this conclusion is robust to the inclusion of several types of relative-price shocks, including shocks to the terms of trade. Research on the optimal price index under PLT is also discussed, and Murchison concludes that, conditional on adopting PLT, the overall CPI would represent close to an ideal index to target.
: Central bank research; Inflation targets; Monetary policy frameworkThis article examines recent research on the influence of various forms of economic uncertainty on the performance of different classes of monetary policy rules: from simple rules to fully optimal monetary policy under commitment. The authors explain why uncertainty matters in the design of monetary policy rules and provide quantitative examples from the recent literature. They also present results for several policy rules in ToTEM, the Bank of Canada's main model for projection and analysis, including rules that respond to price level, rather than to inflation.
: Econometric and statistical methods; Economic models; Monetary policy framework; Uncertainty and monetary policySeveral authors have presented reduced-form evidence suggesting that the degree of exchange rate pass-through to the consumer price index has declined in Canada since the early 1980s and is currently close to zero.
: Exchange rates; Transmission of monetary policyOne of the most important factors that must be considered if countries are thinking about lowering the target level of inflation much below 2 per cent is the zero interest bound. Targeting inflation rates that are too low, the authors note, may restrict the ability of monetary policy to respond to economic shocks by limiting the amount by which interest rates can be eased. The size of the shocks hitting an economy, the formation of inflation expectations, and the conduct of monetary policy are also seen to exert an important influence on the risks of hitting the zero interest bound. The evidence that the authors review suggests that the probability of encountering the zero bound when the average inflation is at least 2 per cent are relatively small.
: Inflation: costs and benefits; Interest rates; Monetary policy implementationThis paper studies the steady-state costs of inflation in a general-equilibrium model with real per capita output growth and staggered nominal price and wage contracts.
: Inflation: costs and benefitsThe authors provide a detailed technical description of the Terms-of-Trade Economic Model (ToTEM), which replaced the Quarterly Projection Model (QPM) in December 2005 as the Bank's principal projection and policy-analysis model for the Canadian economy.
: Business fluctuations and cycles; Economic modelsThe Terms-of-Trade Economic Model, or ToTEM, replaced the Quarterly Projection Model (QPM) in December 2005 as the Bank's principal projection and policy-analysis model for the Canadian economy. Benefiting from advances in economic modelling and computer power, ToTEM builds on the strengths of QPM, allowing for optimizing behaviour on the part of firms and households, both in and out of steady state, in a multi-product environment. The authors explain the motivation behind the development of ToTEM, provide an overview of the model and its calibration, and present several simulations to illustrate its key properties, concluding with some indications of how the model is expected to evolve going forward.
: Business fluctuations and cycles; Economic modelsThe authors develop a small open-economy dynamic stochastic general-equilibrium (DSGE) model in an attempt to understand the dynamic relationships in Canadian macroeconomic data.
: Business fluctuations and cycles; Economic models; Inflation and pricesThis article examines another strategy in the Bank's approach to dealing with an uncertain world: the use of carefully articulated models to produce economic forecasts and to examine the implications of the various risks to those forecasts. Economic models are deliberate simplifications of a complex world that allow economists to make predictions that are reasonably accurate and that can be easily understood and communicated. By using several models, based on competing paradigms, the Bank minimizes policy errors that could result from relying on one view of the world and one philosophy of model design. The authors review some of the models currently used at the Bank, as well as the role of judgment in the projection process.
: Economic models
