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This article describes changes to the structure of ToTEM—the Bank of Canada’s main model for projection and policy analysis—that allow an independent role for long-term interest rates, as well as for the risk spreads that lead to differences in the interest rates faced by households, firms and the government. These changes broaden the range of policy questions that the model can address and improve its ability to explain data. The authors use the model to simulate the effects of shocks to the risk spreads on interest rates similar to those that occurred during the recent financial crisis. They also use the model to assess the macroeconomic impact of higher requirements for bank capital and liquidity.
: Economic models; Financial system regulation and policies; Interest ratesToTEM – the Bank of Canada’s principal projection and policy-analysis model for the Canadian economy – is extended to include inventories. In the model, firms accumulate inventories of finished goods for their role in facilitating the demand for goods.
: Business fluctuations and cycles; Economic modelsInventory investment is an important component of the Canadian business cycle. Despite its small average size – less than 1 per cent of output – it exhibits volatile procyclical fluctuations, accounting for almost one-third of output variance.
: Business fluctuations and cycles; Transmission of monetary policy