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Economic Modelling
journal homepage: www.elsevier.com/locate/ecmod
a r t i c l e
i n f o
Article history:
Accepted 20 October 2014
Available online xxxx
Keywords:
Macroeconomic modeling
Long-run structural VAR
Monetary policy shock
International transmission
a b s t r a c t
This paper estimates a two-country model comprising structural cointegrated models of Canada and the US.
Using persistence prole analysis, we nd that the Term Structure and a modied Fisher equation are maintained
in the US model, and, the Term Structure, Fisher equation and Interest Rate Parity are maintained in the Canadian
model. Then we use the model to examine the transmission of US monetary policy into the Canadian economy.
The results show that the responses of the Canadian macro variables to the US monetary policy shock are very
similar to the responses of the US macro variables to the same shock: after a contractionary US monetary policy
shock, output falls quickly and shows a U-shaped response, ination falls with a delay, short-term interest rate
jumps and then gradually declines and long-term interest rate increases for one year and then gradually declines.
Our results show that interest rate-path-through is the major mechanism by which US monetary policy shocks
are transmitted into the Canadian economy.
2014 Elsevier B.V. All rights reserved.
1. Introduction
It is often stated that when the US sneezes, the rest of the world
catches a cold. Because of strong economic connections between
Canada and the US, Canada is very likely to be inuenced by events in
the US even more seriously than the rest of the world. In particular,
the extent of US monetary policy spillover is a central question for
Canadian policy makers. Policy makers are also interested to know the
role and relevance of different cross-border transmission channels.
These are the issues we will address in this paper.
In order to model the Canadian economy, we follow the Global
Vector Autoregressive (GVAR) modeling strategy which allows for a
rich representation of the cross-country transmission of shocks; see
Pesaran et al. (2004) and Dees et al. (2007a), DdPS. The GVAR model
is constructed from country-specic vector error correction models in
which domestic and foreign variables interact contemporaneously. In
this paper, however, instead of modeling a large set of countries
on which the GVAR is founded, we develop a two-country model comprising a structural cointegrated VARX* for Canada and a structural
cointegrated VAR for the US. This decision is based on the following
reasons. First, the Canadian economy is dominated by the US economy
and direct effects of other countries on Canada are likely to be small.
We will discuss this issue further in Section 3. Second, data for many
(developing) countries is not very reliable. Also, for many countries
data is not available for more than two (or three) decades.
I'd like to thank M. Hashem Pesaran and an anonymous referee for their comments.
E-mail address: barakchian@sharif.edu.
http://dx.doi.org/10.1016/j.econmod.2014.10.036
0264-9993/ 2014 Elsevier B.V. All rights reserved.
12
and Romer (2004), who use a narrative approach based on the minutes
of the FOMC meetings to construct a series of US monetary policy shocks.
The results of the impulse response analysis show that the responses
of the Canadian macro variables to the US monetary policy shock are
similar to the responses of the US macro variables to the same shock:
after a contractionary US monetary policy shock, output falls quickly
and shows a U-shaped response, ination falls with a delay and nally
converges to the initial equlibrium, short-term interest rate jumps and
then gradually declines and long-term interest rate increases for one
year and then gradually declines. Our results also show that increasing
the number of lags in the VAR alleviates the price puzzle.
The major contributions of the paper are threefold. First, we
have spent much time on constructing the USCanada two country
model using the GVAR modeling strategy, and paid much attention to
every detail of the model such as selecting the variables, lags, and
cointegration ranks, specications of the long run relations, etc. This
well-constructed model enables us to answer the questions that the
paper is aimed to address: What are the short run and long run impacts
of US monetary policy on Canadian monetary policy? How does US monetary policy affect Canadian output and prices? Is US monetary policy
transmitted into the Canadian economy through the expenditureswitching-effect mechanism or the interest-rate-path-through mechanism? To our knowledge, this two-country model is new for Canada
and no other paper has yet investigated the impacts of US monetary
policy on the Canadian economy as detailed as this paper. Of course,
the two-country model is a powerful tool to conduct policy analysis for
issues other than those analyzed in the paper. Second, there is a dispute
in the literature regarding the impacts of US monetary policy on the
Canadian economy. We provide compelling evidences that interest ratepath-through is the most important mechanism by which US monetary
policy shocks are transmitted into the Canadian economy. Specically,
our estimations show that as soon as the Fed raises the US short term
interest rate by 100 basis points, the Bank of Canada follows the US by
raising the Canadian short term interest rate by 62 basis points. In addition, the Canadian short term interest rate converges to the US short
term interest rate in the long run reasonably fast. Third, using a wild bootstrap method to produce critical values for the overidentication test
developed for cointegration restrictions, when there is heteroskedasticity
in error terms, is another contribution of the paper.
The remainder of the paper is organized as follows. Section 2 reviews
the literature on cross-country transmission of US monetary policy.
Section 3 describes the two-country VECX* model. Section 4 presents
the empirical results. Section 5 examines the transmission of US monetary policy shocks to the Canadian economy using impulse response
functions. The last section concludes.
2. International transmission of US monetary policy
Does a monetary expansion in the US lead to a recession or a boom
in other countries? From a theoretical point of view, there is not a
conclusive answer to this question. MundellFlemingDurnbush
(MFD) model predicts that in the context of a oating exchange rate
regime, an expansionary US monetary shock leads to a fall in the foreign
output. This is due to the expenditure switching effect. Based on this
theory, an expansionary US monetary shock leads to a devaluation of
the US currency. Since prices are assumed to be sticky, or even xed in
the short run, the relative prices of US products will be decreased.
Hence, US products become more competitive and this will lead to an
improvement in the trade balance. As a result, the US output rises
while the foreign output falls. So expansionary US monetary policy has
a beggar-thy-neighbour effect. Since for the foreign country, imports
are cheaper now and therefore there is a substitution towards imports,
the depreciation of exchange rate leads to a fall in the foreign price level.
In the MFD model it is usually assumed that foreign interest rate is
exogenously set and therefore is invariant to the US monetary policy.
But if foreign monetary authority adjusts its monetary policy in
13
i1
xt zt1 t1 xt
p1
X
i zti a0 ut ;
i1
2
In contrast to the VECMs developed for Canada in the literature (e.g. Hendry, 1995; Armour et al., 1996; Engert and Hendry, 1998; Adam and Hendry, 2000; Kasumovich, 1996,
money measures are not included in our VECX* model. The rationale behind our decision
is based on the three following reasons.
See the Appendix A for more details on the description of the time series.
(i) In recent years, most of the models developed for monetary policy analysis assume that money only plays a passive role. In other words, they assume that money is supplied passively by the central and commercial banks to meet rms' and
households' demand and, therefore, it may be ignored; see e.g. McCallum and Nelson (1999) and Rotemberg and Woodford (1997). It has also been argued that
measures of past ination, economic activity and interest rates contain a great
deal of information embedded in monetary aggregates; see e.g. Gal (2006) and
Woodford (2006), and also the papers presented at the 4th ECB Conference
The role of money: money and monetary policy in the twenty rst century.
(ii) The relationship between money and other economic variables in Canada has not
been stable over time. This observation can be partly explained by the institutional changes and nancial innovations that have occurred in Canada, particularly
after the 1980s, and also the improvement in electronic nancial services. As a result, the ofcial measure of money, M1, does not measure the appropriate measure of narrow money over time; see e.g. Adam and Hendry (2000) and Aubry
and Nott (2000).
(iii) For most of the past four decades, monetary aggregates have played no special
role in conducting monetary policy by the Federal Reserve; for more details
see e.g. Bernanke and Mihov (1998) and Kahn and Benolkin (2007). It has also
been shown that monetary aggregates have negligible prediction power for US
ination; see, for example, Hale and Jord (2007) and Kahn and Benolkin (2007).
14
p
X
i zti a bt Hvt ;
i1
where
xt
e
e ;
e
e ; i 2; ; p1;
e
; 1 I
zt
1
i
i
i1
p
p1 ;
xt
a0
0m m
e
;
a
; b
;
a
0
0
0
m m
I
0
0
u
m
m m
i
m m ; H
e
t
; vt
i
Im
i i 0m m
ut
rt pt b2 2;t ;
Fisher :
l
rt rt b1 1;t ;
TS :
s
PPP :
l
l
rt rt
b3 3;t ;
yt yt b4 4;t ;
et pt pt b5 5;t :
Canada
Lag order
AIC
SIC
AIC
SIC
1
2
3
4
3542.5
3572.0
3581.2
3571.0
3486.2
3475.4
3444.3
3393.8
7504.1
7517.7
7501.3
7479.3
7310.9
7163.5
6986.0
6803.0
Notes: AIC is the Akaike information criterion and SIC the Schwarz information criterion.
The information criteria are computed using 186 observations from 1958Q1 to 2004Q2.
Intercept and trend are included in the estimations. Considering the nature of quarterly
data and the number of observations in each sample, we set the maximum lag order at 4.
Canada
Rank
Trace
CV
-max
CV
0
1
2
3
4
149.5
62.5
33.4
16.1
4.1
82.8
59.1
39.3
23.0
10.5
87.0
29.1
17.2
12.0
4.1
35.0
29.1
23.1
17.1
10.5
Rank
Trace
CV5
CV3
-max
CV5
CV3
0
1
2
3
4
168.4
115.0
75.3
43.2
19.1
135.7
102.4
72.3
46.1
23.1
114.7
85.5
59.3
37.0
18.1
53.4
39.6
32.0
24.1
19.1
49.5
43.6
37.2
30.5
23.1
43.9
38.0
31.8
25.2
18.1
Note: The sample period is 1958Q1 to 2004Q2. CV5 (CV3) denotes the 90% critical value
that assumes the presence of ve (three) exogenous I(1) variables. The order of the underlying VAR is 2 and the model contains unrestricted intercept and restricted trend
coefcients.
15
5
In Fig. 5 we only report the persistence proles of PPP and OC. The results for the persistence proles of the other long run relations are almost identical to Fig. 1. We also investigate the properties of the persistence proles where r = 4 (5 models; TS, Fisher, IRP and
one of PPP or OC are imposed on the Canadian model) and r = 1 (5 models; each of the the
TS, Fisher, IRP, PPP and OC is imposed separately on the Canadian model). In all these
cases, the persistence proles of PPP and OC are almost identical to Fig. 5 and they are very
persistent.
6
Since the real exchange rate shows a small trend over part of the period 1958Q1
2004Q2, we also examined the PPP where co-trending is not imposed on the cointegrating
relation. The persistence prole of the PPP was still persistent although the convergence
towards zero was faster.
16
Canada TS
Canada IRP
1.6
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
1.4
1.2
1
0.8
0.6
0.4
0.2
0
0
12
16
20
24
28
32
36
Canada Fisher
12
16
20
24
28
32
36
28
32
36
US Modified Fisher
1.2
1.2
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0
0
12
16
20
24
28
32
36
24
28
32
36
12
16
20
24
US TS
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
0
12
16
20
Notes: The solid line is the persistence profile generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 1. Persistence proles of the effect of a system-wide shock to the cointegrating relations. Notes: The solid line is the persistence prole generated from the VECX* model and the dashed
lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.
rt pt b20 2;t :
mates are obtained where TS and modied Fisher are imposed on the
US model and TS, IRP and modied Fisher are imposed on the Canadian
17
0.0025
0.0018
0.0016
0.0014
0.0012
0.001
0.002
0.0015
0.0008
0.0006
0.0004
0.0002
0
0.001
0.0005
0
0
12
16
20
24
28
12
US inflation
16
20
24
28
US output
0.004
0.002
0.0018
0.0016
0.0014
0.0012
0.001
0.0008
0.0006
0.0004
0.0002
0
0.002
0
-0.002
12
16
20
24
28
-0.004
-0.006
-0.008
-0.01
0
12
16
20
24
28
-0.012
0.0025
0.0014
0.002
0.0012
0.0015
0.001
0.0008
0.001
0.0006
0.0004
0.0005
0.0002
0
0
12
16
20
24
28
Canadian inflation
12
16
20
24
28
Canadian output
0.004
0.002
0.002
0.0015
0
0.001
12
16
20
24
28
-0.002
0.0005
-0.004
0
0
12
16
20
24
28
-0.0005
-0.006
-0.008
Notes: The solid line is the impulse responses generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 2. Impulse responses to a US monetary policy shock obtained from the VECX* model with two lags. Notes: The solid line is the impulse responses generated from the VECX* model and
the dashed lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.
the Canadian model. This amounts to 7 and 24 over-identifying restrictions for the models of the US and Canada, respectively. The Likelihood
Ratio (LR) statistic for over-identifying restrictions is reported in
Table 5. The LR test is asymptotically distributed by 2(q), where q is
the number of over-identifying restrictions (Pesaran and Shin, 2002).
However, in small samples, this test tends to over-reject (Garratt et al.,
2003). Therefore, we use bootstrap method to generate the critical
values.
4.4.1. Heteroskedasticity
Several studies have recently suggested that over the past two
decades, i.e. the so-called great moderation period, the variances of
the shocks driving macroeconomic and nancial time series have
changed and, in particular, have shown a general decline; see, for
instance, Busetti and Taylor (2003), Kim and Nelson (1999) and Koop
and Potter (2000). Cavaliere et al. (2010) argue that in the context of
time-varying volatility the wild bootstrap scheme is required rather
than the standard residual resampling bootstrap scheme proposed in
the literature (for instance, in Li and Maddala, 1996). That is because
the wild bootstrap replicates the pattern of heteroskedasticity present
in the original shocks.
When we examine the residuals of the error correction equations of
the US and Canadian models, we observe that the residuals of the output
equations in both countries show a clear decline in volatility over the past
two decades. Apart from the changes in volatility due to the great moderation, some other changes in volatility of the residuals can also be
identied. For example, the volatility of the residuals of the oil price
equation markedly increases from the early 1970s (rst oil price shock),
18
0.002
0.001
0.0015
0.0008
0.0006
0.001
0.0004
0.0005
0.0002
0
0
12
16
20
24
28
-0.0005
0
-0.0002 0
12
16
20
24
28
-0.0004
-0.001
-0.0006
US inflation
US output
0.0015
0.004
0.001
0.002
0.0005
-0.002
0
0
12
16
20
24
12
16
20
24
28
28
-0.0005
-0.004
-0.001
-0.006
-0.0015
-0.008
0.002
0.0008
0.0015
0.0006
0.0004
0.001
0.0002
0.0005
0
0
12
16
20
24
28
-0.0002
-0.0005
-0.0004
-0.001
-0.0006
Canadian inflation
0.004
0.001
0.002
0.0005
-0.002
0
4
12
16
20
24
12
16
20
24
28
Canadian output
0.0015
12
16
20
24
28
28
-0.0005
-0.004
-0.001
-0.006
-0.0015
-0.008
Notes: The solid line is the impulse responses generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 3. Impulse responses to a US monetary policy shock obtained from the VECX* model with eight lags. Notes: The solid line is the impulse responses generated from the VECX* model and
the dashed lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.
and the volatility of the residuals of the US short and long term interest
rates rises over the period 19781982 (the Volcker shock period).
Table 4 presents the results of heteroskedasticity test for the
residuals of the error correction equations. The null hypothesis of
homoskedasticity is rejected for ve equations at 1% and for two
equations at 10% signicance levels.
Therefore, we employ the wild bootstrap procedure with the bootstrap residuals generated according to the technique proposed in
Cavaliere et al. (2010). See Appendix A for a description of the bootstrap
procedure.
To our knowledge, no one has yet investigated the statistical properties of the wild bootstrap scheme for the over-identifying restrictions
test. The wild bootstrap has not also been used in any empirical study
to compute the critical values of the over-identifying restrictions test.
19
1.5
0.5
1
0.5
-0.5
0
0
12
24
36
48
60
72
84
12
24
36
48
60
72
84
-0.5
-1
-1
-1.5
-1.5
US inflation
US output
0.03
0.003
0.02
0.002
0.01
0.001
0
-0.01 0
0
0
12
24
36
48
60
72
84
12
24
36
48
60
72
84
-0.02
-0.001
-0.03
-0.002
-0.04
-0.003
-0.05
-0.004
-0.06
1.5
0.6
0.4
0.5
0.2
0
-0.5
12
24
36
48
60
72
84
0
-0.2 0
12
24
36
48
60
72
84
-0.4
-1
-0.6
-1.5
-0.8
-2
-1
Canadian inflation
0.003
Canadian output
0.01
0
0.002
-0.01
0.001
12
24
36
48
60
72
84
-0.02
0
0
12
24
36
48
60
72
84
-0.001
-0.03
-0.04
-0.002
-0.05
-0.003
-0.06
-0.004
-0.07
Notes: The solid line is the impulse responses generated from the single equation model and the dashed lines are the
90% confidence bands produced by Monte Carlo methods (500 replications) following the methodology in Romer and
Romer (2004, footnote 17).
Fig. 4. Impulse responses to the Romer & Romer shock obtained from a single equation model. Notes: The solid line is the impulse responses generated from the single equation model and
the dashed lines are the 90% condence bands produced by Monte Carlo methods (500 replications) following the methodology in Romer and Romer (2004, footnote 17).
maintained in the model of the US and the Term structure, Fisher equation and Interest Rate Parity are maintained in the model of Canada.
Fig. 1 shows that the persistence proles of all ve long run relations
in the VECX* model die out very fast after a system-wide shock hits
the cointegrating relations. The half life of the shocks ranges from only
one quarter for the US modied Fisher equation to six quarters for the
Canadian Term Structure relation. This conrms that the theoretic
long run relations are empirically valid.
4.5. Error Correction Equations of the Canadian Model
The estimates of the reduced form error correction equations of the
Canadian model with a number of diagnostic statistics are reported in
20
Canada OC
Canada PPP
1.6
1.6
1.4
1.4
1.2
1.2
0.8
0.8
0.6
0.6
0.4
0.4
0.2
0.2
0
0
12
16
20
24
28
32
36
12
16
20
24
28
32
36
Notes: The solid line is the persistence profile generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 5. Persistence proles of the effect of a system-wide shock to the cointegrating relations. Notes: The solid line is the persistence prole generated from the VECX* model and the dashed
lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.
Second, the effect of oil price changes in all equations is very small
and mostly insignicant. Its effect on output is signicantly positive,
though very small. This observation is consistent with other studies
which nd oil price level to be almost neutral for the Canadian economy
(see Bashar et al., 2013, and IMF, 2005).
Third, in the output equation, the TS term is signicant (at 5% level).
It shows that raising short term interest rate relative to long term
interest rate has a considerable signicant negative effect on output
which is consistent with studies like Estrella and Mishkin (1998).
Fourth, in all the equations, the analogous US variable (at time t) is
highly signicant (at 1% level). The sign of the coefcient of the US
variable is positive and its size is considerable. In particular, the coefcient of rlt in the equation of the Canadian long term interest rate
(rlt), is 0.875, which shows that 1% increase in the US long term interest
rate raises the Canadian long term interest rate by 0.9% within the
quarter. This result demonstrates the strong and quick effect of the US
economy's uctuations on the Canadian economy.
Fifth, the IRP error correction term, ^3;t1 , enters signicantly in all
equations except the ination equation. The sign of ^3;t1 in all these
equations is economically meaningful. This interesting result underlines
the fact that the US monetary policy drives the Canadian economy via
interest rate path-through mechanism.
Sixth, in the short term interest rate equation, only ^3;t1 and rst
are signicant at 5% signicance level.7 Therefore, we can present the
short term interest rate equation as:
s
s
rt 0:213 ^3;t1 0:622 rt u2t :
0:093
0:091
10
8
See the website of the parliament of Canada at http://www2.parl.gc.ca/
HousePublications/Publication.aspx?DocId=1040348.
&Language = E&Mode = 1&Parl = 36&Ses = 2.
9
As another example, John Crow (2002, pp. 152153), Governor of the Bank of Canada
19871994, discusses this strategy in the case of the Canadian response to the Volker disination: At the start of the 1980s, the Bank's monetary policy was to all intents forced by
events outside our borders - namely, the great America disination led by the Federal Reserve's
Paul Volcker. Confronted itself with the fallout from the U.S. decision to confront ination,
the Bank of Canada decided to try to hang on to the U.S. dollar exchange value for our currency.
This meant, in practice, at least matching U.S. rate increases.
Table 5
Long run over-identifying restrictions test.
Lag order
US (*)
1:6418
1:9536
1:8055
1:4243
1:5609
Canada ()
1:4490
1:7146
1:5220
2:2003
1:6312
0:3772
0:5893
0:5068
0:4805
0:8239
0:2901
0:9294
1:7938
0:3265
0:6089
Note: The US cointegrated model is estimated with two long run relations (TS and
modied Fisher) and the Canadian cointegrated model is estimated with three long run
relations (TS, modied Fisher and IRP). Critical value for a one tailed t test at 5%
signicance level is 1.645. * denotes signicance at 5% level. The sample period is
1958Q1 to 2004Q2.
Table 4
Heteroskedasticity test.
US
Canada
21
rst
rlt
pt
yt
pot
0.366
17.798***
9.802***
3.489*
19.351***
ert
rst
rlt
pt
yt
0.540
3.647*
8.592***
10.139***
0.832
Notes: The US cointegrated model is estimated with two long run relations (TS and
modied Fisher) and the Canadian cointegrated model is estimated with three long run
relations (TS, Fisher and IRP). * ,** and *** denote signicance at the 10, 5, and 1% levels.
Critical values of 2(1) for 10, 5 and 1% signicance levels are 2.706, 3.841 and 6.635,
respectively. The sample period is 1958Q1 to 2004Q2.
US
Canada
LR statistic
Bootstrap scheme
CV 90%
CV 95%
CV 99%
33.65
24
61.42
Standard
Wild
Standard
Wild
21.27
25.57
59.32
63.82
24.57
30.39
64.29
69.30
31.68
43.16
73.46
80.90
Note: The US cointegrated model is estimated with two long run relations (TS and
modied Fisher) and the Canadian cointegrated model is estimated with three long run
relations (TS, Fisher and IRP). The critical values are simulated using both the standard
and wild bootstrap schemes. The sample period is 1958Q1 to 2004Q2. # denotes the
number of over-identifying restrictions.
10
All the estimations, construction of the VECX* model, and generation of the persistence proles and impulse response functions were done using the GAUSS software.
22
Table 6
Error correction equations of the Canadian model.
Equation
ert
rst
rlt
2pt
yt
^
1;t1
0:217
0:003
0:041
0:199
0:462
^
2;t1
0:331
0:031
0:008
0:171
0:037
^
3;t1
2:513
0:213
0:113
0:193
1:110
ert 1
0:043
0:009
0:001
0:033
0:019
rst 1
3:028
0:078
0:115
0:205
0:432
rlt 1
0:337
0:046
0:073
0:096
0:418
2pt 1
0:319
0:046
0:010
0:295
0:093
yt 1
0:104
0:014
0:005
0:039
0:085
rst
1
2:627
0:167
0:078
0:435
0:483
rlt 1
2:066
0:010
0:045
0:026
1:333
2pt 1
0:109
0:023
0:002
0:232
0:255
yt 1
0:158
0:016
0:010
0:028
0:181
pot 1
0:000
0:001
0:001
0:005
0:004
0:592
0:284
1:367
0:077
1:233
2:942
0:388
0:233
1:580
3:152
0:547
0:238
0:015
0:040
0:019
0:093
0:005
0:084
0:200
0:026
0:016
0:107
0:214
0:037
0:016
0:001
0:016
0:008
0:037
0:002
0:034
0:080
0:011
0:006
0:043
0:086
0:015
0:006
0:000
0:112
0:054
0:259
0:015
0:234
0:557
0:074
0:044
0:299
0:597
0:104
0:045
0:003
0:194
0:093
0:447
0:025
0:403
0:963
0:127
0:076
0:517
1:031
0:179
0:078
0:005
rst
1:629
0:622
0:004
0:216
0:113
rlt
2:460
0:262
0:875
0:195
1:047
2pt
0:291
0:042
0:015
0:468
0:144
yt
0:282
0:020
0:000
0:090
0:335
pot
0:019
0:002
0:001
0:000
0:010
R
SC : 2(1)
FF : 2(1)
N : 2(2)
HS : 2(1)
1:339
1:992
0:520
0:215
0:014
0:091
0:135
0:035
0:015
0:001
0:037
0:054
0:014
0:006
0:000
0:254
0:377
0:099
0:041
0:003
0:438
0:652
0:170
0:070
0:005
0.039
0.576
0.753
0.338
0.341
0.575
0.104
20.99
0.540
1.582
1.003
2.003
3.647
.019
.951
13.46
8.592
4.231
2.911
10.62
10.139
1.744
0.206
7.83
0.832
Note: The error correction terms ^1;t1 ; ^2;t1 and 3;t1, correspond to the Term Structure,
Fisher equation and Interest Rate Parity, respectively. , and denote signicance
at the 10, 5, and 1% levels. SC is a test for serial correlation, FF a test for functional form, N a
test for normality and HS a test for heteroscedasticity. Critical values are 3.84 for 2(1) and
5.99 for 2(2). The sample period is 1958Q1 to 2004Q2.
It is well know that the lag order selected for a VAR model can
affect the dynamic properties of impulse responses and can even change
the interpretation of impulse response estimates of a VAR; see
e.g. Hamilton and Herrera (2004) and Kilian (2001). Faced with a
problem similar to ours, Bluedorn and Bowdler (2011) nd that the
price responses depend crucially on the number of lags of the monetary
policy shock included in the model: by increasing the number of
monthly policy shock lags from 6 to 48, the price puzzle disappears
while preserving many of the other impulse responses.
It is generally accepted in the literature that monetary policy takes
more than one year to be transmitted fully into the economy and
empirical studies in this area usually consider between 1 to even
4 years lag in their models. Romer and Romer (2004), for example,
include three years lag in their VAR and four years lag in their single
equation model when estimating the response of price to monetary
policy shock.
Lag order selection for a VAR is a sensitive issue with serious consequences. Abadir et al. (1999) show that adding irrelevant variables
(lags) to a nonstationary VAR increases the bias of all the estimators
(this is in contrast with the theory for stationary data where adding
irrelevant variables (lags) increases the variance of estimators but
does not affect biases). They also show that as the dimension of the
VAR increases the variance and hence the mean squared error of the
estimators increases. Their ndings therefore favor parsimonious
modeling.
Consistent with the results of Abadir et al., it is widely believed that a
more parsimonious lag structure in a VAR leads to a better forecasting
performance. For example, Ltkepohl (1985, 1991) shows that the
VARs with the lag orders selected by the SIC perform better in shortrun forecasting. It is well known that the SIC generally underestimates
the lag order of a VAR in small samples and therefore selects a more
parsimonious model.
However, when it comes to impulse response functions the story
changes dramatically. Using a Monte Carlo experiment, Kilian (2001)
shows that the effects of overtting and undertting a VAR are strongly
asymmetric for impulse response functions and the costs associated
with undertting tend to be disproportionately larger. Kilian suggests
that it is safer to include extra lags (even higher lag orders than
suggested by the AIC) rather than to truncate the lag order early. In
summary, it seems that the literature suggests one to select different
lag orders for different purposes: a more parsimonious lag order for
short (to medium) run forecasting whereas a less parsimonious lag
order for impulse response analysis.
Concerned with the extra cost of undertting, we set the maximum
lag at 8, and we increase the number of lags in our model between p = 2
to p = 8. The results show that increasing the number of lags alleviates
the price puzzle, indeed.
Fig. 3 presents the IRFs derived from the VECX* model with p = 8.11
After a contractionary US monetary policy shock, US output falls very
quickly and shows the well-known U-shaped response; the monetary
shock reaches its maximum impact on output after 2 years; the US
ination rises rst and then falls; however, it rises signicantly only in
the rst quarter after the shock and then starts to decline; it becomes
negative after ve quarters and the negative impact on the US ination
becomes marginally signicant after about two years (between the 8th
and 15th quarters); nally the US ination converges to the initial
equilibrium; the US short-term interest rate jumps immediately after
the shock and peaks in the rst quarter and then gradually falls; and
the US long-term interest rate jumps instantly after the shock, peaks
after one year and then steadily declines.
The IRFs of the Canadian variables are similar to the IRFs of the US
variables. Actually, the responses of the Canadian short and long term
interest rates are almost identical to the responses of the US interest
rates. The response of the Canadian ination is slightly weaker and
slower than that of the US ination and the negative response never
becomes signicant. But the negative effect of a contractionary US
monetary shock on the Canadian output is more persistent than on
the US output.12 The responses of the Canadian variables apparently
conrm the interest rate-path-through mechanism as opposed to the
MFD mechanism.
5.2. Impulse Response Function using Romer and Romer (2004) Shock
In order to assess the reliability of the IRFs simulated using the VECX*
model, we also estimate another set of IRFs using Romer and Romer's
(2004) monetary policy shock series. Romer and Romer (2004) employ
a narrative approach to construct a series of US monetary policy shocks
for the period 19691996. They estimate a reaction function in which
the desired Fed Funds target rate, as agreed to at Federal Open Market
Committee (FOMC) meetings, is the dependent variable and the
estimates/forecasts for unemployment, real GDP growth and the change
in the GDP deator, taken from the Greenbook forecasts, are the
explanatory variables.13 The error term from this reaction function is
interpreted as the monetary policy shock. Following Romer and Romer
11
The results for the models with the other lag orders are available upon request.
We also examined whether the IRFs obtained from the VECX* model is sensitive to the
value of * and in Eq. (9). The results show that the variation of * and , where
* {1, 2.0}, {1, 2.2}, has almost no effect on the IRFs in the rst year after the shock
and a marginal effect after the rst year.
13
The Greenbook forecasts are prepared by the Federal Reserve staff and are presented
to the FOMC before each meeting.
12
xt a0
I
X
i1
bi xti
J
X
c j st j et ;
j1
where x is the macro variable of interest and st is the Romer & Romer
shock measure. Our regression runs from 1970:01 to 2004:06.15 The
decision to exclude any other explanatory variable from the regression
is based on the assumption that the shock is not affected by other
explanatory variables that inuence the dependent variable. In other
words, the shock is purely exogenous with respect to other variables
by construction. Based on this assumption, the estimates of the coefcients of the regression equation will be unbiased. The dependent
variables, x, are monthly US and Canadian industrial production (IP),
consumer price ination (CPI), treasury bill rate and 10-years government bond rate. Following Romer and Romer (2004), the number of lags
of dependent variable, I, is set at 24, and the number of lags of the shock,
J, is set at 36 (48) for IP (CPI). We set a shorter lag structure for interest
rates, where I = 12 and J = 24, because nancial variables are believed
to respond to shocks more quickly. However, the shape of the responses
of the interest rates to the US monetary shock remain virtually the same
when different combinations of the lag structures (I,J) are considered.
Following Romer and Romer, we assume that the monetary shock
does not affect IP and CPI within the month. However, we allow the
shock to impact interest rates contemporaneously. These assumptions
are consistent with the recursive structure of Christiano et al. (1996,
1999).
The responses of the level of the variables to a Romer & Romer shock
of one percentage point are reported in Fig. 4. The impulse response
functions estimated using the Romer & Romer shock are similar to the
IRFs obtained using the VECX* model with eight lags (Section 1). After
a contractionary US monetary policy shock, US output falls very quickly
(after a small rise at the beginning) and show the well-known U-shaped
response; the monetary shock reaches its maximum impact on output
after two years; the US ination rises rst and then starts to decline;
ination falls below zero after about two years and remains negative
for the rest of the horizon (the high variation of the ination's impulse
response is due to the high volatility of monthly ination); one
difference between these IRFs and the IRFs obtained from the VECX*
model is that the responses of the US and Canadian ination rates
remain signicantly negative after almost four years using the Romer
& Romer shock, whereas they converge to zero in the VECX* model.
This is consistent with the Romer and Romer's (2004) claim that the
response of price to the Romer & Romer shock is stronger than the
response to the shocks derived from the standard recursive identication schemes. The US short-term interest rate jumps immediately
23
14
Romer and Romer (2004) use the single equation regression method to estimate the
effects of the Romer & Romer shock on the US economy. Scrimgeour (2010) uses the same
method to estimate the effects of the Romer & Romer shock on four countries in the
Americas. Our exercise in this section deviates from these studies in several respects,
though in essense is similar to them. First, we use an extended series of the Romer &
Romer shock (our series end in 2004:06 instead of 1996:12). Second, we estimate the response of consumer price ination, and not price level, to the shock (Romer and Romer estimate the effects on the level of PPI for nished goods and Scrimgour does not estimate
the effects of the shock on price level). Third, we estimate the responses of both short
and long term interest rates to the shock where I = 12 and J = 24 (Romer and Romer
do not estimate the effect of the shock on interest rates and Scrimgour esimates only
the response of the short-term interest rate, where he considers I = 24 and J = 36).
15
See Barakchian and Crowe (2013) on how the Romer & Romer shock is extended from
1997:01 to 2004:06. Similar to Romer and Romer (2004), the regression is run from
1970:01 with the values of st before 1969:03 are set at zero.
24
0 1
ut
p
X
zt
14
0m m
Im
to obtain
1
zt
p
X
P0 H
i zti P0 H
a P0 H
bt t
i1
zt CLa bt Hvt
where
t
11
t
;
ut
where
covt
C j L j C1 1LC L;
covt ; t cov t ; ut
covut ; ut
cov ut ; t
with
j0
bt vt :
0 1
P
0mm
P0 H
C L
aH
i1
CL
i zti H
i1
i zti a bt Hvt :
0 1
and the identication conditions are given by (i) covt Im , (ii) P
is lower triangular.
Now, consider the VAR representation of the VECX* model (Eq. (3))
and premultiply it by H1,
P0
t P
"
zt
C j L j;
and C j
j0
0
1
cov t ; t Im ; cov t ; ut cov P
ut ; ut
0 1
Ci ;
u ;u ; covut ; ut u :
i j1
t
X
Hv j C LHvt v0 ;
zt z0 b0 t C1
12
j1
xt
p
X
i xti a b t ut :
13
i1
0 1
0 1
xt
0 1
i xti P
0 1
a P
0 1
b tP
0 1
ut
1 e
HP S ; i 1; ; m ; n 0; 1;
sir f n; z : i p C
ii n 0 i
15
The algorithm used to produce condence bounds for the persistence proles and impulse response functions is as follows:
Step 1: We follow Cavaliere et al. (2010) and generate the bootstrap
^ t n ; t 1; ; T , according to the device presented
residuals, v
in Eq. (15).
Step 2: Similar to the standard bootstrap procedure, as in e.g. Li and
Maddala (1996), we construct the bootstrap sample z(n)
t , t =
1, , T, recursively using the VAR representation of the VECX*
model
n
zt
^ H
^ zn
^ zn a
^v
^ bt
^ tn ; t 1; ; T;
1 t1
2 t2
16
^ ;
^ ;a
^ ^
where
1
2 ; b and are the estimates of the parameters
of the model obtained from the estimation over 1958Q1
2004Q2, and the actual realizations are used for the initial
values, z1, , zp.
Step 3: Using the simulated sample z(n)
t , t = 1, , T, a structural
cointegrated VARX* for Canada and a structural cointegrated
VAR for the US are estimated for given long run relations. The
short run parameters are re-estimated at each iteration of the
bootstrap procedure. After that, we combine the Canadian
and US models to create a new VECX* model and generate
persistence proles and impulse response functions from the
bootstrapped VECX* model.
Step 4: We iterate Steps 1 to 3, N times to generate N samples of the
persistence proles and impulse response functions.
A.4. Unit root tests
Table 7
Augmented DickeyFuller unit root test for the rst differences of the variables.
ert
rst
rlt
pt
2pt
yt
rst
rlt
pt
2pt
yt
pO
t
ADF(0)
ADF(1)
ADF(2)
ADF(3)
ADF(4)
12.42
10.50
11.60
4.15
19.20
10.51
10.80
10.36
3.79
17.36
9.62
10.09
8.52
9.60*
9.58
3.00
13.66
7.30
10.97
8.78
3.05
14.24
6.87*
9.37
6.06
7.23
6.94
2.47
9.65
5.39
6.42
6.39
2.34
8.21*
6.21
6.71
5.30
7.17
5.87
2.49
10.05
6.02*
6.33
6.28
2.87*
7.63
6.46
667
5.77*
6.04
6.53*
1.93*
9.11*
5.55
4.59*
6.77*
2.67
7.00
5.88
6.75*
Table 8
Augmented DickeyFuller unit root test for the levels of the variables.
ert
rst
rlt
pt
yt
rst
rlt
pt
yt
pot
ADF(0)
ADF(1)
ADF(2)
ADF(3)
ADF(4)
1.83
1.72
1.43
1.13
1.38
1.66
1.45
0.44
2.17
1.37
1.99
2.26
1.62*
0.63
1.61
2.19
1.81
1.12
2.68
1.85
2.14
1.96*
1.51
1.06
1.77
1.63
1.72
1.46
2.99*
1.58
2.58*
2.14
1.65
1.40
2.73
1.89
1.72
1.35
1.73*
2.10
1.79
1.51*
2.63
1.63
2.02
2.31*
1.94*
1.99
2.98
1.82*
Notes: For the rst differences, ADF regressions include an intercept and p lagged rst
differences of dependent variable. But for the levels, ADF regressions include an intercept,
a linear time trend and p lagged rst differences of dependent variable, except for rst, rlt, rst
and rlt which only include intercept. The relevant 5% critical values are 2.88 for the case
with just intercept and 3.45 for the case with both intercept and trend. Symbol * refers
to the order of augmentation chosen by the AIC with a maximum lag order of four. The
sample period is 1958Q1 to 2004Q2.
25
Table 9
PhilipsPerron unit root test for the rst differences of the variables.
ert
rst
rlt
pt
2pt
yt
rst
rtl
pt
2pt
yt
pot
PP(0)
PP(5)
PP(10)
PP(15)
PP(20)
9.28
7.64
6.17
3.84
15.30
8.32
8.11
7.08
2.67
12.24
8.53
4.93
9.74
11.27
14.96
3.58
24.46
6.61
8.46
10.88
2.66
19.24
8.24
6.90
11.14
11.62
15.54
3.37
29.17
6.7
8.37
12.20
2.74
20.58
9.04
6.98
13.22
13.00
17.32
3.28
30.80
5.84
8.73
13.39
2.98
21.09
9.28
7.14
14.69
14.35
18.55
3.21
31.95
5.74
8.88
13.59
3.28
20.66
10.32
7.53
Table 10
PhilipsPerron unit root test for the levels of the variables.
ert
rst
rlt
pt
yt
rs
rlt
pt
yt
pot
PP(0)
PP(5)
PP(10)
PP(15)
PP(20)
1.66
1.06
0.88
1.31
1.43
0.99
0.99
0.49
2.17
1.59
1.49
1.16
0.90
0.66
0.26
1.26
0.88
0.24
1.73
1.26
1.47
1.35
1.08
0.55
1.29
1.37
1.09
0.20
2.05
1.25
1.55
1.50
1.12
0.51
1.38
1.46
1.07
0.19
2.43
1.23
1.70
1.67
1.21
0.51
1.45
1.59
1.11
0.19
2.69
1.22
Notes: PP() represents PhillipsPerron test with Bartlett window of size . For the rst
differences, underlying DF regressions include an intercept but for the levels, DF regressions include an intercept and a linear time trend, except for rst , rlt, rst and rlt which
only include intercept. The relevant 5% critical values are 2.88 for the case with just
intercept and 3.45 for the case with both intercept and trend. The sample period is
1958Q1 to 2004Q2.
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