Publications and Research

Highlights of Medium-term Policy Relevant Research: Update 2007

Introduction

There are eight main themes in the research program for 2007:

Theme 1: Inflation Targeting
Theme 2: Global Economic Developments and their Implications for Canada
Theme 3: Productivity, Labour Supply, and Potential Output
Theme 4: Financial System Efficiency
Theme 5: Financial System Stability
Theme 6: Currency and New Technologies
Theme 7: Operational Efficiency in Funds Management Activities
Theme 8: Macroeconomic Models for Policy Analysis

Theme 1: Inflation Targeting

Policy issue:

In order to ensure that Canadians have the very best monetary policy regime in place, responsible public policy demands that we continuously conduct economic research evaluating whether the current inflation-targeting regime, established in the 1990s, is delivering the greatest contribution to Canadian economic performance. With this in mind, the Bank plans to lead a concerted effort to learn from our experience and the experience of others, and to examine whether and how the monetary policy framework in Canada might be improved. In the Bank of Canada's background document to the 2006 renewal of the inflation control targets two issues were identified for further economic research, viz., the potential costs and benefits of (i) targeting a lower rate of inflation; and (ii) pursuing a price-level target instead of an inflation target.

It should be emphasized that this research will not be conducted by Bank of Canada researchers alone. Indeed, we envision engaging outside researchers into this research program at many different levels. In 2007, for instance, we have organized workshops and conferences with expert-academic researchers, central bank researchers from across the world, as well as Canadian public policy makers and researchers.

Research questions:

Q1: Are there gains in economic welfare from having a lower inflation target, and how might they be affected by the zero bound on nominal interest rates? Are there practical ways to avoid or minimize the zero-bound problem?

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 price-level target? How large are these costs, and how can they be minimized?

Q3: What are the benefits of reduced price-level uncertainty? 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? 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 quantify some of the benefits and costs? Which price index should be targeted?

Q5: To what extent is the choice of monetary policy framework in an economy such as Canada influenced by the choice of monetary policy framework in other countries (such as the United States)? Does this affect the balance of benefits and costs associated with price-level targeting versus inflation targeting?

The research program undertaken by the Bank will address these questions, as well as any necessary reassessment of issues covered in the past, and any new issues that may arise. The temporal goal is to complete this research well before 2011 (the year of our next renewal) so as 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 are able to access our past and present pieces of inflation targeting research.

Theme 2: Global Economic Developments and their Implications for Canada

Policy issue:

A key challenge for monetary policy is to identify and understand the developments in the world economy that might affect in a major way, either directly or indirectly, economic activity and inflation in Canada. The objective of this research is to improve our understanding of the implications of globalization for the Canadian economy, notably the sectoral and regional aspects of the adjustment process to global competitive pressures. To this end, a number of questions have been identified by the Economic Departments for their 2007 research program.

Research questions:

Q1: What has been the effect of China on global inflation?

Q2: What has been the impact of China's entry into the WTO on prices, wages, and the structure of the Canadian economy?

Q3: What is the impact of emerging Asia on world and Canadian commodity prices?

Q4: Has the expenditure-switching effect of a change in the real exchange rate declined in the United States in recent years? What role can expenditure switching play in the rebalancing of global imbalances?

Q5: How do commodity price shocks affect the real exchange?

Q6: How do macroeconomic fundamentals interact with the structure of the foreign exchange market to affect exchange rate dynamics? The case of the Canadian dollar.

Q7: What are the sectoral and regional aspects of the adjustment process in Canada to recent relative price shocks and their macroeconomic implications?

Theme 3: Productivity, Labour Supply, and Potential Output

Policy issue:

Potential output provides a measure of the productive capacity of an economy and deviations of the level of economic activity from its productive potential may provide warning signals of inflationary or disinflationary pressures. When an economy is producing at its productive capacity, potential output growth provides a rough indication of the rate at which the economy can grow without inciting 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. While demographic change has been an ongoing process in Canada, labour market implications of an aging population will become more acute in the coming years. In particular, the trend growth rate of labour supply is expected to start declining as the retirement rate of older workers increases relative to the entry-rate of new workers. At the same time, there continues to be considerable uncertainty about the future productivity trend in Canada. Whereas both Canada and the Unites States experienced a period of strong productivity growth from the mid-1990s to the early 2000s, productivity growth in Canada subsequently faltered and a widening productivity gap emerged between the two countries. Understanding what factors may have contributed to the shortfall of average productivity growth rates in Canada relative to the United States may provide insight into the likely prospects for renewed convergence to U.S. productivity growth, stronger potential output growth, and greater improvements in Canadian living standards.

Research questions:

Q1: What is the current level of the output gap in Canada and how is the potential growth rate of the Canadian economy likely to evolve?

Q2: What structural factors explain the historical behaviour of Canadian labour productivity, including differences between Canadian and U.S. productivity experiences?

Q3: How will structural factors and government policies affect Canadian labour supply in the context of a population aging?

Q4: What are the prospects for and determinants of output growth in the major economies over the medium to long term? In particular, what are the effects of differential rates of demographic and productivity growth? What lessons can be learned for Canada from these international comparisons?

Theme 4: Financial System Efficiency

Policy issue:

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

The specific factors that affect the efficiency of financial institutions, markets and infrastructure are not well understood. Information is, however, known to be an especially critical element 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 liquidity and price discovery in fixed income markets as well as the overall cost of capital for Canadian firms. We will also continue to analyze competition and efficiency in the banking sector. Another part of our research agenda is to deepen our understanding of financial infrastructure, focused currently on gaining a better understanding of the elements that contribute to payment system efficiency. This research into payment system efficiency includes an analysis of the network of relationships between participants and how efficiency changes as concentration in the banking sector increases. 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: What factors might be inhibiting the efficiency of the Canadian financial system and, therefore, productivity of the economy as a whole?

Q2: How might clearing and settlement systems in Canada operate more efficiently without compromising safety?

Theme 5: Financial System Stability

Policy issue:

While there is a growing consensus about the main elements of a good monetary policy framework, there is less agreement concerning the appropriate framework to promote financial stability. Developing such a framework is a main objective of the new Bank of Canada medium-term plan and various research activities are expected to contribute to achieving that objective.

A component of financial stability frameworks that is gaining in importance is macro stress-testing. Macro stress-tests are analysis of a financial system capacity to absorb unlikely but plausible adverse shocks. Our existing macro stress-testing tools will be further developed to cover more sectors of the Canadian economy and to integrate more sophisticated statistical techniques. In particular, given that stress-testing models are used to assess the impact of unusually large shocks, we will examine non linearities that may characterize responses to such shocks. Our stress-testing tools will be used in the context of the 2007 Canadian Financial Sector Assessment Program (a standard IMF surveillance tool). Their application will be focused on the Canadian banking sector.

Academic researchers have developed structural models to analyze financial stability issues. These models include various features thought to be important for financial stability analysis, including key financial channels, non-linear responses to shocks, and deviations of asset prices from their fundamental value. In 2007 we will do a preliminary assessment of some of these models. This should help us orient our future modeling efforts.

Researchers are developing a new approach to assess international risks. This new approach, which will include a multi-country macroeconomic model, should allow for a more systematic identification and analysis of risks originating outside Canada.

Having a well-functioning payment, clearing and settlement (CPS) system is key to financial stability. Interlinkages between systems and between financial institutions may be a source of risk and a determinant of how shocks propagate through the financial system. Implications of these interlinkages are an important 2007 research theme. Operational risk in CPS systems is also a concern for central banks, and research in this area will continue; with a focus on how interlinkages affect operational risk.

We are hoping that this year's Bank of Canada economic conference, under the theme "Developing a Framework to Assess Financial Stability", will help us make progress in our quest for a framework.

Research questions:

Q1: What is a good framework to assess financial stability?

Q2: How resilient is the Canadian financial system?

Q3: How can we improve our approach to the identification of international risks to Canadian financial stability?

Q4: How do linkages between CPS systems and financial institutions, domestically and globally, affect financial system stability?

Theme 6: Currency and New Technologies

Policy issue:

The Currency research program reflects the fact that new technologies are both challenges and opportunities for bank notes. The Bank's counterfeit analysis program monitors the challenge of technologies and materials which counterfeiters may use. At the same time, the Bank will evaluate or facilitate the development of technologies which provide opportunities to strengthen the security of our notes. During 2007, the primary focus will be on the continuation of a multi-year research program leading to a new generation of bank notes planned for issue starting in 2011. Bank technical staff and the RCMP will continue to assess existing and emerging technologies available to counterfeiters of bank notes. Scientific research and development will contribute to the selection of future bank note materials and security features. Finally, policy and strategic research is required to address a number of issues that will arise as planning for the development of the next generation of bank notes begins.

There are also opportunities to improve the performance of notes in circulation. A program to measure the condition of circulating notes will continue in 2007; as well, new technologies to increase the durability of notes will be assessed through laboratory and circulation tests. A review of the Bank Note Distribution System and research with retailers will also assess the approaches and incentives required to motivate an appropriate level of checking bank notes in circulation for authenticity.

Fundamental research will add to our understanding of the factors that influence confidence, which is a key ingredient in the Bank's "commitment to Canadians" about currency, and counterfeiting, which is the manifestation of a problem in a currency system, in order to decide which measures most effectively promote the one and prevent the other. Looking to the longer term prospects for bank notes as a retail means of payment, further theoretical and empirical research is needed to understand who uses bank notes, how they are used, and what is the future of bank notes compared to other means of payment - how they can play the most productive role possible within Canadian society.

The Bank has a strong reputation for collaborative research. Research and development will continue to be done with others when this approach improves the potential for success. Organizations in Canada and internationally are being engaged in projects that we believe will deal with existing and emerging threats and opportunities.

Research questions:

Q1: What security features, material, and technologies should be adapted or developed for possible inclusion in the next generation of bank notes?

Q2: What factors influence the quality and authenticity of circulating bank notes?

Q3: What factors influence confidence and counterfeiting?

Q4: Why are Canadians using payment instruments the way they do, and what is the likely evolution of bank notes relative to other payment instruments?

Theme 7: Operational Efficiency in Funds Management Activities

Policy issue:

The Bank strives to be efficient in all of its operations. Seeking increased efficiency in relation to its role as fiscal agent for the Government of Canada, as well as in its financial market operations on its own account, will continue to be an area of focus in 2007.

As fiscal agent for the Government of Canada, the Bank seeks to provide high-quality, effective, and efficient funds management services, including 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 number of ways of improving these services further.

One important issue in this area to which research can contribute is the optimal structure of the government's debt, in terms of the distribution of its liabilities by maturity and instrument type. In 2007 work will be undertaken to implement a model of the debt structure, incorporating the joint evolution of the yield curve and macro fundamentals. In relation to the foreign reserves, there is a similar set of issues in relation to the optimal distribution of the government's foreign reserve assets, for instance by currency and maturity, and the liabilities which finance them. Research will focus on developing models to help inform policy choices in those areas.

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, both as an input to producing economic projections for the Canadian and international economies, but also as tools for the analysis of a wide range of policy questions, including many of those listed in the above themes. In addition, large increases in computing power combined with advances in modeling techniques, which have occurred over the last decade, means 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 (DSGE) 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. Work is currently underway to formally estimate ToTEM's dynamics, as well as to evaluate the model's empirical properties. In addition to more accurate projections, formal estimation will provide a measure of the associated parameter uncertainty. This information can be used to better inform senior management on how to conduct monetary policy in an environment of model uncertainty.

Work will also continue on refining MUSE, the Bank of Canada's main forecast model of the US economy, which has rich theoretic underpinnings and is sufficiently disaggregated to be used for a wide-range of policy relevant questions. Principal among the development projects planned for MUSE is the addition of a fully-specified labour market.

The Bank will continue to refine its newly-developed global economic model (GEM), which is currently used to assess the effects of global shocks on major countries or economic regions and their impact on Canada. Work is underway that will eventually allow the staff to do welfare analysis with GEM, which will further broaden the set of policy issues for which GEM can be utilized.

A major initiative is also underway to model the linkages between real and financial variables in a DSGE framework when both businesses and households face credit constraints. Work will continue on this front including further refinements to the current prototype as well as formal estimation and evaluation of the completed model. This work is ultimately intended to aid staff in identifying potential risks to the Staff Economic Projection.

In addition to structural general equilibrium models, the Bank continues to develop new reduced-form models for economic analysis and forecasting. Many of these models will include financial variables, including micro-financial data. These models are most often used to identify those 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 behaviours, including those of financial market participants, financial institutions, and clearing and settlement systems. Examples of new models under development include: models to extract interest 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 portfolio of foreign exchange reserves.