The asymmetric reaction of monetary policy to inflation and the output gap: Evidence from Canada

This paper empirically analyzes the interest rate behavior of the Canadian monetary authorities by taking into account possible asymmetries in the loss function. We employ a switching regime framework using two estimation strategies: First, we follow Caner and Hansen's (2004) threshold approach. Under this procedure we estimate, using the Taylor empirical rules, the threshold values. Second, to infer the monetary policy preferences and have the best interpretation of the parameters, we use these threshold values to estimate the specification of asymmetric policy reaction function following Favero and Rovelli's (2003) approach. The results reveal that the Canadian monetary authorities showed asymmetric preferences; hence its reaction function can be better modeled as a nonlinear model. The results also imply that the monetary authorities' preferences have changed between different subperiods and different regimes. In particular, the parameter associated with the implicit target of inflation has been reduced significantly. We find strong statistical support for this decline, a result that is consistent with previous findings by Favero and Rovelli (2003) for the case of US and Rodríguez (2008) for Canada. The main contribution of this paper is to make out the presence of nonlinearities and asymmetries in the Canadian reaction function and to be able to interpret the parameters associated with the preferences of the central bank. This provides empirically interesting extension to Rodriguez (2008).