A Comparison of Optimal Policy Rules for Pre and Post Inflation Targeting Eras: Empirical Evidence from Bank of Canada

A Comparison of Optimal Policy Rules for Pre and Post Inflation Targeting Eras: Empirical Evidence from Bank of Canada

Title:

A Comparison of Optimal Policy Rules for Pre and Post Inflation Targeting Eras: Empirical Evidence from Bank of Canada

Number:

14/13

Author(s):

Neslihan Kaya

Language:

English

Date:

May 2014

Abstract:

In this paper, we derive policy rules of Bank of Canada for different preferences over the goal variables in their loss functions. The optimal rules are derived for the pre and post inflation-targeting eras. According to the results, the monetary policy rule of the Bank of Canada for the pre inflation-targeting era is best described with a loss function that attaches equal weight to inflation, interest rate smoothing incentive and the output gap in the loss function. In the post-inflation targeting era the optimal interest rate attaches the highest weight to inflation rate in the loss function; followed by the interest rate smoothing incentive and then the output gap. The inclusion of the exchange rate as another goal variable in the loss function does not significantly alter the results in approximating the actual policy rate of Bank of Canada. Next, simulations of demand (positive) and supply (negative) shocks are carried out for the post-IT period for two cases where the monetary policy rule is mimicked by (i) an ad-hoc Taylor rule and (ii) the derived optimal rule. The results indicate that the ad-hoc Taylor rule brings down inflation rates more quickly compared to the derived optimal rule, but only at the cost of higher contraction in output and more volatile interest rates.

Keywords:

Inflation targeting, Optimal monetary policy rule, Linear-quadratic regulator problem

JEL Codes:

E52; E58; C63

A Comparison of Optimal Policy Rules for Pre and Post Inflation Targeting Eras: Empirical Evidence from Bank of Canada
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