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

Ronald Henry Lange


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.

Full Text:




Ang, A. & Bekaert, G. (2002). Regime switches in interest rates. The Journal of Business and Eco-nomics 20, 163-182.

Armour, J., Engert, W. & Fung. B. (1996). Overnight innovations as a measure of monetary policy shocks in vector autoregressions. Bank of Canada Working Paper, no. 96-4.

Bernanke, B. & Mihov, I. (1998). Measuring monetary policy. The Quarterly Review of Economics 113, 869-902.

Blanchard, O &Quah, D . (1989). The dynamic effects of aggregate demand and supply disturbances. The American Economic Review 79, 655–673.

Boivin, J. & Giannoni, M. (2002a). Assessing changes in the monetary transmission mechanism: A VAR approach. Federal Reserve Bank of New York, Economic Policy Review, May 97-111.

Boivin, J. & Giannoni, M. (2002b). Has monetary policy become less powerful? Federal Reserve Bank of New York Staff Reports, no. 144.

Chen, S. 2006. Revisiting the interest rate-exchange rate nexus: a Markov-switching approach. The Journal of Development Economics 79, 208-224.

Christiano, L., Eichenbaum, M. & Evans, C. (1999). Monetary policy shocks: What have we learned and to what end? Handbook of Macroeconomics, eds M. Woodford and J. Taylor, North Hol¬land.

Christiano, L.J., Eichenbaum , M. & Evans, C .( 2005). Nominal rigidities and the dynamic effects of a shock to monetary policy. The Journal of Political Economy 113, 1-45.

Clarida, R., Gali, J, & Gertler, M. (2000). Monetary policy rules and macroeconomic stability: evi¬dence and theory. The Quarterly Review of Economics 115, 147-180.

Ehrmann, M., Ellison , M. & Vallac, N. (2001). Regime-dependent impulse response functions in a Markov switching vector autoregression model. Bank of Finland Discussion Papers, no. 11.

Ehrmann, M., Ellison, M. & Vallac, N. (2003). Regime-dependent impulse response functions in a Markov switching vector autoregression model. Economic Letters 78, 295-299.

Fujiwara, I. (2003). Has the effect of monetary policy changed during 1990s?. Osaka School of Inter¬national Public Policy, Discussion Paper 03-08.

Fujiwara, I. (2006). Evaluating monetary policy when nominal interest rates are almost zero. The Journal of the Japanese and International Economies, 20, 434–453.

GALÍ, J. (1992). How well Does the IS-LM Model fit postwar U.S. data? The Quarterly Journal of Economics, 107, 709–738.

Gelfand, A. & Smith, A.. (1990). Sampling-based approaches to calculating marginal densities. The Journal of the American Statistical Association 85, 398-409.

Girardin, E & Moussa, Z. (2009). The effectiveness of quantitative easing in Japan: New evidence from a structural factor-augmented VAR, mimeo, Papers/MoussaEDGE2008.pdf.

Gonzalez, A & Garcia, J. (2006). Structural changes in the transmission mechanism of monetary Pol¬icy in Mexico: A non-linear VAR approach. Bank of Mexico Working Paper 2006-06

Gordon, D. B., & E. Leeper, E. M. (1994). The dynamic impacts of monetary policy: An exercise in ten¬tative identification. The Journal of Political Economy 102, 1228–1247.

Hamilton, J. (1989). A new approach to the econometric analysis of nonstationary times series and business cycles. Econometrica 57, 357-84.

Hamilton, J. (1990). Analysis of time series subject to change in regime. The Journal of Econometrics 57, 357-384.

Herwartz, H. & Lutkepohl, H. (2014(. Structural vector autoregressions with Markov-Switching: Combining conventional with statistical identification of shocks. Journal of Econometrics 183, 104-116.

Hubrich, K. & Tetlow, R. (2015). Financial Stress and Economic Dynamics: The transmission of crises. Journal of Monetary Economics 70, 100-115.

King, R., Plosser, C, Stock, J.H. & Watson, M. (1991). Stochastic trends and economic fluctuations. The American Economic Review 81, 819–840.

Krolzig, H. (1997). Markov Switching Vector Autoregressions: Modelling, Statistical Inference and Applications to Business Cycle Analysis. Berlin: Springer-Veriag.

Krolzig, H. (2001). Business cycle measurement in the presence of structural change: international evidence. The International Journal of Forecasting 17, 349-368.

Krolzig, H. & Toro, J. (2005). Classical and modern business cycle measurement: the European case. The Spanish Economic Review 7, 1-21.

Lange, R. (2013). Monetary policy reactions and the exchange rate: a regime-switching structural VAR for Canada. The International Review of Applied Economics 27, 612-632.

Paolillo, R. M. & Petragallo, N. (2004). Asymmetries of monetary policy transmission between US and Euro area, mimeo,¬loPetragallo.pdf.

Sims, C. (1980). Macroeconomics and reality. Econometrica 48, 1-48.

Sims, C., Stock, J. & Watson, M. (1990). Inference in linear time series models with some unit roots. Econometrica 58, 113-144.

Sims, C. & Zha, T. (2006). Are there regime switches in US monetary policy? The American Eco¬nomic Review 96, 54-81.

Rubio-Ramírez, J-F, Waggoner, D. & Zha, Z. (2005). Markov-switching structural vector autoregres¬sions: Theory and application. Federal Reserve Bank of Atlanta, Working Paper 2005-27.

Smets, F. & Wouters, R. (2002). An estimated dynamic stochastic general equilibrium model of the Euro area. The Journal of the European Economic Association 1, 1123-1175.

Soledad, M. & Martinez, P. (2002). A regime-switching approach to the study of speculative attacks: a focus on EMs crises. Empirical Economics 27, 299-334.



  • There are currently no refbacks.

Paper Submission E-mail:

Applied Economics and Finance    ISSN 2332-7294 (Print)   ISSN 2332-7308 (Online)

Copyright © Redfame Publishing Inc.

To make sure that you can receive messages from us, please add the '' domain to your e-mail 'safe list'. If you do not receive e-mail in your 'inbox', check your 'bulk mail' or 'junk mail' folders. If you have any questions, please contact: