The Monetary Transmission Mechanism and Inflation Targeting: A Regime-Switching VAR Approach for Canada

Abstract

This study employs a Markov-switching VAR with regime-dependent dynamics to assess the trans­mission mechanism of monetary policy in Canada. The regime-switching estimations divide the sam­ple period stochastically into two continuous regimes that corresponds to the periods before and after explicit-inflation targeting in Canada. The empirical results indicate relatively large differences in both the innovation process due to the variance component of the VAR and the propagation mech­anism due to the regime-dependent systematic component. The pre-targeting regime corresponds to much larger innovations in the macroeconomic variables and overall larger systematic responses of the macroeconomic variables to the innovation processes, suggesting a stronger monetary transmis­sion mechanism in the regime. However, variance decompositions and counterfactual analysis sug­gest that monetary policy has become more responsive to fluctuations in output growth and inflation in the target regime. Overall, about 80 per cent of the variations in the monetary policy rate in the current regime can be explained by the systematic reactions of policy to output growth and inflation at the relevant policy horizons.