Publications and Research

Highlights of Medium-term Policy Relevant Research: Update 2009

Introduction

There are nine main themes in the research program for 2009:

Theme 1: Inflation Targeting
Theme 2: Global Economic Developments
Theme 3: Productivity, Labour Supply, and Potential Output
Theme 4: Financial System Efficiency and Risk
Theme 5: Financial System Stability
Theme 6: Currency and Bank Note Security
Theme 7: Operational Efficiency in Funds Management Activities
Theme 8: Macroeconomic Models for Policy Analysis
Theme 9: Real-Financial Linkages

Policy issue:

While the current inflation-targeting regime has served Canadians well, exploring whether the monetary policy framework can be further improved is a matter of responsible public policy. To this end, a major research program was initiated in 2006 in anticipation of the next renewal of the inflation target in 2011. The research program focuses on two central questions: (i) Would an inflation target that is lower than our current 2 per cent target lead to better economic outcomes? and (ii) What are the costs and benefits of price-level targeting relative to inflation targeting? Given recent economic events, in addressing these questions, greater attention will be devoted to the implications of the effective lower bound (ELB) for the design of the monetary policy framework. In addition, the Bank is committed to advancing research on how best to achieve the current inflation objective at the ELB.

Research questions:

Q1: Would a lower inflation target improve economic welfare, and how might the benefits be affected by the zero bound on nominal interest rates?

Q2: What are the key frictions that give rise to transition costs as the economy moves from one targeted inflation rate to another, lower one, or from an inflation target to a price-level target? How large are these costs, and how might they be minimized?

Q3: What are the potential welfare gains from price-level targeting, especially in regard to facilitating long-run investment decisions and the use of long-term, nominal-debt contracts? In particular, what are the benefits of reduced long-run price-level uncertainty? Would price-level targeting mitigate the zero-bound problem?

Q4: What are the relative merits of inflation targeting versus price-level targeting in an open economy susceptible to large and persistent terms-of-trade movements? Can models of the global economy help to quantify some of the benefits and costs? Which price index should be targeted?

Q5: Are there important complementarities between different countries' choice of monetary policy regime, and if so, do they affect the balance of benefits and costs associated with price-level targeting versus inflation targeting? In particular, to what extent is the choice of monetary policy framework in one country (such as Canada) influenced by the framework chosen in other countries (such as the United States)?

Q6: How might policy-makers deal with data uncertainty and parameter uncertainty that cannot be directly controlled by the central bank?

Q7: What are the advantages and disadvantages of increasing monetary policy transparency?

The research program undertaken by the Bank will address these questions, in addition to ongoing assessment of issues covered in the past and of new issues that may arise. The goal is to complete this research before 2011 (the year of our next renewal) to ensure sufficient time for open discussion and debate of the results and their implications. In an effort to help disseminate our research on a timely basis, we have created a website (www.inflationtargeting.ca) where researchers can access our past and current inflation-targeting research.

Theme 2: Global Economic Developments

Policy issue:

A key challenge for monetary policy is to identify and understand the developments in the world economy that might have a major influence on economic activity and inflation in Canada. In light of the current global economic crisis, research initiatives in 2009 are geared towards getting a better understanding of real-financial linkages in our econometric models, refining our forecasting models for major economies, improving our knowledge of commodity markets, and examining the exchange rate and its implications for monetary policy.

Research questions:

Q1: What factors deserve more attention in evaluating U.S. economic prospects? In particular, which U.S. activities/sectors most affect the Canadian economy, and through which channels?

Q2: What are the prospects for emerging economies (notably in Asia), for growth, and for greater economic and financial integration into the global economy?

Q3: What are the major short- and long-run determinants of world commodity prices?

Q4: What factors influence movements in the Canadian dollar, and how should monetary policy react to them?

Theme 3: Productivity, Labour Supply, and Potential Output

Policy issue:

Potential output provides a measure of the productive capacity of an economy. Deviations of the level of economic activity from potential are important determinants of inflationary or disinflationary pressures. Improving our understanding of the evolution of trend labour supply and trend productivity underpins better estimation and projection of potential output for Canada. A priority for research over the medium term is to reassess the outlook for potential output growth in the context of changing demographics and challenges related to productivity. The trend growth rate of labour supply is expected to start declining, owing to declining fertility rates, stabilization of the labour force attachment of women, and an increase in the retirement rate of older workers relative to the entry rate of new workers.

Productivity grew strongly in both Canada and the United States from the mid-1990s to the early 2000s, in the context of a cyclical upswing and the boom in information and communications technology (ICT), but productivity growth in Canada subsequently faltered. The reasons for this slowdown likely include the cyclical downturn, smaller benefits from ICT adjustment costs associated with large relative price movements, a relatively weak demand for innovation, and disincentives associated with the limited size and density of domestic markets for non-tradables. Prospects for renewed convergence to U.S. productivity growth may be related to economic structure as well as to convergence pressures and diminishing adjustment costs.

Research questions:

Q1: What are the current levels of potential output and the output gap in Canada, and how are they likely to evolve?

Q2: How is productivity growth in Canada affected by exogenous shocks? What structural factors influence the transmission of these shocks to productivity?

Q3: What structural factors influence Canadian labour supply?

Q4: What are the prospects for and determinants of output growth in the major economies over the medium to long term?

Theme 4: Financial System Efficiency and Risk

Policy issue:

An efficient financial system is critically important to the long-run stability and growth of the Canadian economy and has immediate implications for the effectiveness of monetary policy and our fiscal agency responsibilities. The Bank of Canada thus has a strong interest in promoting the efficiency of the Canadian financial system.

In the recent crisis, there has been a renewed interest in understanding the origins of liquidity risk and credit risk and how they should be optimally managed. Our work is thus focused on the macroeconomic origins of these risks, and how agency problems may have augmented them. In addition, we will examine how risk is handled in the financial system via collateral policies.

The degree of asymmetric information is known to be especially critical to the efficient functioning of financial markets and institutions. Thus, a major thrust of our research agenda is to develop a better understanding of how asymmetric information inhibits financial system efficiency. To this end, our research is investigating the drivers of market liquidity and price discovery in fixed-income and foreign exchange markets. In addition, we will examine the effects of the short sales restrictions imposed on financial firms.

Another part of our research agenda is to deepen our understanding of financial infrastructure and markets. We will focus on understanding the trade-offs between risk and efficiency. This research includes an analysis of the risk and efficiency trade-offs in the generation of market liquidity as well as the study of the efficiency-risk properties of private and public payment and settlement systems. Furthermore, we will continue our analysis of the network of relationships between system participants and its implications for efficiency and risk.

The final part of our research will focus on the vulnerability of Canadian and foreign firms during the crisis. For example, we will examine the effects of the crisis on financial investment policies. Overall, this research agenda is focused on identifying areas where the efficiency of the financial system in Canada can be improved without compromising the safety or integrity of the system.

Research questions:

Q1: How do credit risk premiums vary over time? What macroeconomic factors are they related to?

Q2: How do asymmetric information, liquidity, and market structure affect the efficiency of fixed-income, foreign exchange, and equity markets and the banking industry? How do regulatory changes affect the functioning of these markets?

Q3: How have firms changed their investment and financing policies as a result of the crisis?

Q4: How might clearing and settlement systems and core financial markets in Canada operate more efficiently without compromising safety?

Theme 5: Financial System Stability

Policy issue:

In light of the ongoing financial crisis, one of the Bank of Canada's main objectives is to conduct research on potential regulatory reforms for the financial sector. Macro-prudential surveillance is needed to mitigate systemic financial risks and the adverse effects on the aggregate real economy. In addition, procyclical features of the current regulatory system may contribute to a build-up of real financial imbalances. In order to contribute effectively in this area, we will focus on analyzing and understanding financial institution behaviors and incentives and their implications for liquidity, funding, risk, executive compensation, and balance-sheet management. Research on these issues will be a priority.

Work on developing a framework for assessing financial stability continues. Work to identify, assess, and communicate risks in a more analytically rigorous fashion is underway. Another important component of the financial stability framework is macro stress testing. We will continue work on modelling and integrating different types of risks, and assessing the role of bank interlinkages as contagion channels for stress.

Identifying and assessing risks from clearing and settlement systems will be another priority. Research will also focus on interlinkages between financial markets and institutions and how robust infrastructure and central bank liquidity contribute to stable financial institutions and continuously open core funding markets, which are essential elements to a stable financial system.

Research questions:

Q1: What financial sector regulatory reforms should be adopted to reduce the likelihood or severity of the next financial crisis?

Q2: What is a good framework for assessing financial stability?

Q3: How might we measure the systemic importance of financial institutions and the resilience of the Canadian financial system?

Q4: How can we improve our approach to the identification and analysis of domestic and international risks to Canada's financial stability?

Q5: How do links between PCS systems and financial institutions affect the stability of the financial system at the national and international levels?

Q6: How can we improve the Bank's liquidity policy?

Q7: What is the nature of the interlinkages between liquidity provisions by financial institutions and market liquidity?

Q8: How have financial institutions changed their balance sheets over time? How heterogeneous are they across institutions?

Q9: What are the options for keeping core funding markets continuously open, and how do these options compare in their effectiveness and impact on market efficiency?

Theme 6: Currency and Bank Note Security

Policy issue:

Research relating to currency examines the longer-term prospects for the use of bank notes as a means of retail payment and considers how best to address the need for Canadian bank notes to remain fit for use and secure against counterfeiting for as long as they circulate. Within this context, further theoretical and empirical economic research is needed to understand the future of bank notes compared with other means of payment. We will conduct a survey on the means of payment that consumers choose at the point of sale. The survey data will be used to estimate an econometric model of consumers' decisions regarding the adoption and usage of means of payment. In addition, we will start work on building a theoretical model of counterfeiting in which consumers have access to a technology that produces counterfeit bank notes and sellers can verify the bank notes they receive by incurring a cost. The goal of this work is to better understand what factors influence, and how various policy measures affect, the counterfeiting of bank notes.

With the aim of ensuring that Canadian bank notes remain fit for use and secure against counterfeiting, we are evaluating technology and materials to make bank notes more secure. We are also studying policy and strategic issues related to the conditions and processes necessary for the circulation of current notes and to the development of new bank notes. Our focus will remain on the development of the new generation of bank notes planned for issue beginning in 2011. At the same time, we will continue our ongoing assessment of counterfeiting methods and materials, our evaluation of available security features, and our efforts to promote the development of security features employing new concepts. In addition, we will continue studies on the quality of bank notes in circulation; the efficacy of methods to measure, anticipate, and improve durability; and the ability to authenticate notes in circulation.

In keeping with past approaches and philosophy, the Bank will continue to work collaboratively with other institutions, such as the RCMP, financial institutions, retail associations, academic and research facilities, other central banks, and international suppliers and currency organizations.

Research questions:

Q1: Why are Canadians using payment instruments the way they do, and what is the likely evolution of bank notes relative to other payment instruments?

Q2: What security features, materials, and technologies should be adapted or developed for possible inclusion in the next generation of bank notes?

Q3: What factors influence the quality of notes and the public's ability to authenticate them?

Theme 7: Operational Efficiency in Funds-Management Activities

Policy issue:

As fiscal agent for the Government of Canada, the Bank seeks to provide high-quality, effective, and efficient funds-management services, in relation to the management of the government's foreign exchange reserves (the Exchange Fund Account) and the government's treasury and domestic debt operations. While the current system is operating well, the Bank is looking at a several ways to improve these services further. We will continue to conduct research that leads to effective policy advice on the domestic debt program and foreign reserve management in view of evolving borrowing requirements and market conditions.

One important issue in this area is the optimal structure of the government's debt, with regard to maturity and instrument type. Significant effort over the past few years has gone into developing and implementing a model of the debt structure that incorporates the joint evolution of the yield curve and macro fundamentals. This work places the Bank of Canada at the forefront of international efforts to investigate the optimal structure of government debt in the face of a complex set of issues. In 2009, in view of the changing economic environment, additional refinements to the stochastic simulation model used to support strategic decisions will be considered. As well, further fundamental research on auction formats will be pursued to seek increased effectiveness and efficiency in the provision of funds-management services.

In relation to the foreign exchange reserves, there is a similar set of issues connected with the optimal distribution of the government's foreign reserve assets (for instance by currency and maturity) and the liabilities that finance them. We will advance our research in this area by reviewing existing literature on asset-liability matching models and foreign reserves management with the intent to inform our future modelling choices. In addition, we will continue the work on developing a term-structure model for the Exchange Fund Account.

Research questions:

Q1: What is the optimal structure of Government of Canada debt?

Q2: What is the optimal structure of the government's foreign reserve assets and liabilities?

Theme 8: Macroeconomic Models for Policy Analysis

Macroeconomic models play a crucial role at the Bank of Canada, informing projections for the Canadian and international economies and serving as tools for analyzing a wide range of policy questions, including many of those listed in the above themes. Large increases in computing power, combined with the advances in modelling techniques that have occurred over the past decade, mean that the economist's toolbox is more sophisticated than ever.

Examples of models that are currently used or under development include sticky-price dynamic stochastic general-equilibrium models with and without financial frictions; multiple-sector and multi-country general-equilibrium models; financial models; and reduced-form forecasting models. ToTEM, an open-economy dynamic stochastic general-equilibrium model featuring both nominal and real rigidities, has been in use as the main projection model for the Canadian economy since December 2005. Progress has been made towards formally estimating ToTEM's dynamics and evaluating the model's empirical properties. Ongoing work builds on this progress and expands its scope to include estimation of long-term trends. Moreover, work will continue to explore ways of modelling linkages between the real and financial sectors in ToTEM. Several other enhancements to ToTEM will also be completed, including allowing for non-linear dynamics and explicitly incorporating inventories into the model.

Work will also continue on improving MUSE and GPM (Global Projection Model), the Bank of Canada's main forecasting models of the U.S. and global economies. Both models have strong theoretic underpinnings and are sufficiently disaggregated to be used for a wide range of policy-relevant questions.

The Bank will continue to refine its global economic model (BoC-GEM – Bank of Canada Global Economic Model), which is currently used to assess the effects of global shocks on major countries or economic regions, as well as their impact on Canada. It is also used as a research tool to address questions such as the relative merits of inflation targeting vs. price-level targeting in a global framework, the impact of emerging Asia on prices, and global imbalances. Work is underway to use the model to assess the impact of international risks on financial stability. This will be achieved by adding a banking sector and financial accelerator to the model. A semi-finished goods sector will also be introduced to the model, mainly to improve the Emerging Asia block.

In addition to structural general-equilibrium models, the Bank continues to develop new reduced-form models for economic analysis and forecasting. Some of these models will include financial variables, including micro-financial data. These models are most often used to identify the variables that are useful indicators for monetary policy. Some of these models will also be used to help staff understand the nature and magnitude of the risks associated with the Staff Economic Projection.

The Bank is also expanding the range of financial models that it uses to conduct research and analysis into financial behaviour, including the behaviour of financial market participants, financial institutions, and clearing and settlement systems. Examples of new models under development include models to extract interest-rate expectations from asset prices; models of credit risk and its relationship to macroeconomic variables; and models of participant behaviour in Canada's Large Value Transfer System.

Models of the yield curve and its drivers are also being developed to aid in the management of the government's debt structure and its portfolio of foreign exchange reserves.

Economic models, however sophisticated, represent deliberate abstractions from reality and may be misspecified in important ways. In addition, there may be considerable uncertainty around the parameters that govern the model's dynamic properties, owing to insufficiently long data sets. Staff will continue to develop explicit measures of model uncertainty associated with projections of the Canadian and foreign economies. This information will be used to better inform senior management on the level and principal sources of uncertainty. In addition, an optimal monetary policy reaction function that explicitly factors in this uncertainty will be tested in ToTEM.

Q1: What is the most effective way of measuring and communicating to policy-makers the uncertainty associated with model-based projections and policy analysis? What forms of uncertainty are most relevant to policy?

Q2: What are the implications of various forms of uncertainty for the conduct of monetary policy? For instance, how does model uncertainty influence the relative merits of inflation targeting versus price-level targeting?

Q3: From the point of view of monetary policy in Canada, what are the most important linkages between the real and financial sides of the economy, and how should these linkages be captured in our macro models?

Q4: How can we introduce a meaningful financial sector into BoC-GEM and our U.S. model, MUSE, to capture the links between financial and macroeconomic developments?

Q5: How can we use GPM to improve our rest-of-world projections and ensure global consistency in the outlook for exchange rates, international trade flows, and policy effects? How can we best incorporate commodity prices into our global projection using GPM?

Theme 9: Real-Financial Linkages

While the Bank has undertaken efforts over a considerable period to strengthen the analysis of linkages between financial and macroeconomic developments, these linkages have gained prominence during the recent financial crisis. Capturing these linkages requires going beyond standard economic models, which accord only limited roles for financial variables. This work is all the more important to policy during periods when financial markets are turbulent or when policy rates are at their effective lower bound. Given the challenges encountered to date, progress will require a diverse set of theoretical and empirical approaches and a focus on developing new data sets and analyzing existing data that until now have received limited attention in the literature.

With these points in mind, a research priority over the medium term will be to develop theoretical and empirical models that aid the Bank's decision makers in understanding how domestic and international financial developments affect the Canadian economy and the monetary policy transmission mechanism. These tools will guide the Bank's policies as new financial and macroeconomic developments emerge. Furthermore, research analyzing the linkages between real and financial variables will help policy-makers to identify areas where the Bank's monetary policy and financial system functions overlap and exhibit potential complementarity. Finally, this research activity will be conducted by internal and external researchers via joint collaboration and workshops.

Q1: How do we introduce a meaningful financial sector into economic models in order to capture and improve our understanding of the linkages between financial and macroeconomic developments? What financial frictions are key for these linkages?

Q2: How does the health of the balance sheets of financial intermediaries, households, and businesses affect monetary policy and the macroeconomy?

Q3: How should monetary policy be conducted during a financial crisis or when the policy rate is at the effective zero lower bound? How can unconventional monetary policy be operationalized in economic models with multiple assets? What are the effects of financial shocks on the real sector and on the conduct of monetary policy?

Q4: What are the implications of financial sector regulatory reform and financial innovation for the macroeconomy and the conduct of monetary policy?

Q5: Which financial variables, credit spreads, and asset prices should we monitor and analyze to understand the effects of financial developments on the macroeconomy and monetary policy? Would placing greater emphasis on financial variables improve our monitoring of the economy and, hence, our policy advice?