Model stability in the quantitative analysis of Canadian monetary policy
Date
1993
Authors
Chan, Elsie Suet Fong
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Abstract
The purpose of this study is to examine the stability of a small macroeconometric model describing Canadian monetary policy over the 1972-1989 period. Specifically, Gregory and Raynauld's (1985) model with rational expectations restrictions imposed is used to examine whether there are structural changes during the 1970s and the 1980s, and to identify whether the changes are associated with changes in the economic structure or in the execution of monetary policy.
As the descriptive analyses of Canadian monetary policy indicate, there were changes in the execution of the Bank of Canada's policy during the 1970s and the 1980s. Financial innovations and technological advancements constituted major changes to the economic structure in the 1980s. Based upon this descriptive information, it is desirable to examine empirically whether a model based on the economic structure and monetary policy in the 1970s can be appropriately used to explain the economic structure and the Bank of Canada's policy in the 1980s.
After the appropriate lag structures for the system of equations are chosen, the system is estimated using the Full Information Maximum Likelihood method over the period 1972Ql to 1989Q4. The Rational Expectations Hypothesis is tested. Godfrey's (1988) likelihood ratio test is used to examine the structural changes over the 1972Ql-1989Q4 period. This study further extends the analysis to identify the causes of the structural changes.
The systemwide stability test result suggests structural changes occurred during the 1970s and the 1980s. The results from further stability tests indicate that although both the conduct of Canadian monetary policy and the structure of the economy changed during the last two decades, the latter is the more important source of structural instability.
The overall evidence suggests that the model is not robust over time, and that the model cannot be used to describe Canadian monetary policy over the 1980s. The empirical analyses further suggest that the Canadian economy has undergone some major changes, such as financial innovations, and technological advancements during the 1980s. This evidence is consistent with the descriptive analyses.