Exchange rate stability and monetary policy in Canada: A Markov-switching DSGE approach

This study estimates the monetary policy rule in Canada using a Markov-switching dynamic stochastic general equilibrium (DSGE) model. The interest rate policy rule is estimated based on two blocks in which the underlying regimes are different: the response of the interest rate to the changes in the inflation rate and output gap (i.e., traditional Taylor rule block in a closed economy) and the response to the exchange rate change. Each block is independently estimated by dividing it into two regimes with strong and weak interest rate responses. According to the estimation results, the period estimated to be a regime that strongly (weakly) responds to the inflation rate and output gap is simultaneously a period of a regime that weakly (strongly) responds to the exchange rate change. As interest rates have different purposes in each block, a trade-off between the two goals is in line with the following trilemma: exchange rate stability and monetary autonomy for internal balance are not simultaneously achieved in an open capital market. Considering that the above trilemma is binding, our counterfactual experiments show that a monetary policy that does not responds strongly to exchange rate changes performs better in terms of welfare in general but this is not always the case for certain types of shocks.