Inflation Targeting in Canada: An Expected Loss Analysis in a DSGE Model with Trade Costs

Abstract

This paper develops an open economy DSGE model with an emphasis on trade costs to evaluate the performance of the Bank of Canada in the Canadian inflation targeting experience. For model parametrization, the New-Keynesian Phillips curve for the Canadian economy, together with the monetary policy rule of the Bank of Canada, is estimated. When a utility-based expected loss function is considered, the Bank of Canada is found to be far from being optimal in its actions, independent of trade costs. When an ad hoc expected loss function considering the volatilities in inflation, output and interest rate is considered, it is found that the actions of the Bank of Canada are explained best when trade costs in fact exist but the Bank of Canada ignores them. In other words, the Bank of Canada can employ a better monetary policy by considering the existence of trade costs. Thus, trade costs play an important role in forming the monetary policy rules, which is ignored in the literature. Finally, given the ad hoc loss function, the actions of the Bank of Canada are best explained when 70% of weight is assigned to inflation, 15% of weight to interest rate and 15% of weight to output.