The Dynamic Behaviour of Canadian Imports and the Linear-Quadratic Model: Evidence Based on the Euler Equation

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We examine the ability of the simple linear-quadratic model under rational expectations to explain dynamic behaviour of aggregate Canadian imports. In contrast to authors of previous studies who examine dynamic behaviour using the LQ model, we estimate the structural parameters using the Euler equation in a limited information framework that does not require an explicit solution for the model's control variables in terms of the exogenous forcing variables. In the first stage of our two-step methodology, we find statistically stable long-run elasticities of domestic activity and relative price to be about 1.5 and -0.5 over the sample period of estimation. In the second stage, we use the parameter estimates from the first stage and estimate the Euler equation. These empirical estimates imply that adjustment costs are about 9 to 13 times more important than disequilibrium costs. In sum, we find surprisingly encouraging evidence supporting the view that the LQ model is not inconsistent with the dynamic behaviour of Canadian aggregate imports.