Taylor rules and the Canadian-US equilibrium exchange rate

This paper identifies the Canadian-US equilibrium exchange rate based on a simple structural model of the real exchange rate, in which monetary policy follows a Taylor rule interest rate reaction function. The equilibrium exchange rate is explained by relative output and inflation as observable variables, and by unobserved equilibrium rates as well as unobserved transitory components in output and the exchange rate. Using Canadian data over 1974- 2008 we jointly estimate the unobserved components and the structural parameters using the Kalman filter and Bayesian technique. We find that Canada's equilibrium exchange rate evolves smoothly and follows a trend depreciation. The transitory component is found to be very persistent but much more volatile than the equilibrium rate, resulting in few but prolonged periods of currency misalignments.