Monetary Policy Transmission in a Small Open Economy: The Role of Expected Inflation and Real Interest Rates
Rokon BhuiyanABSTRACT
Background
Some previous macroeconomic studies report puzzling responses of variables due to monetary policy shocks. This paper argues that these anomalies occur because information regarding inflationary expectations utilized by central banks for policy decisions is not sufficiently incorporated into traditional VAR models. Given the significant impact of expected inflation and ex‐ante real interest rates on households, firms, and policymakers, a more comprehensive approach is needed.
Methods
This study identifies the Bank of Canada's monetary policy function by incorporating expected inflation and ex‐ante real interest rates alongside other domestic and foreign variables within an open‐economy structural VAR model. This framework aligns the identified reaction function more closely with actual policy behavior to yield a more precise measure of exogenous monetary policy shocks.
Results
The empirical findings indicate that the Bank of Canada significantly contracts monetary policy in response to an unexpected rise in expected inflation. Furthermore, the results demonstrate that the monetary transmission mechanism in Canada operates effectively through both the interest rate and exchange rate channels.
Conclusion
By sufficiently accounting for inflationary expectations and ex‐ante real interest rates, this open‐economy framework successfully resolves traditional monetary policy puzzles and provides a more accurate depiction of the transmission channels in Canada.