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Highlights of Medium-term Policy Relevant Research: Update 2006

Introduction

Leading-edge research is a key element of the Bank's Medium-Term Plan (2003-2006). Research is vital for the Bank to meet its commitment to excellence in each of its functions: monetary policy, financial system, currency, and funds management. By asking some fundamental questions and seeking the answers we expand our policy-relevant knowledge.

There are nine main themes in the research program for 2006:

Theme 1: Inflation Control Strategy
Theme 2: Analysing Major Global Developments and Their Potential Impact on Canada
Theme 3: Productivity, Labour Supply, and Potential Output
Theme 4: Asset Prices
Theme 5: Financial System Efficiency
Theme 6: Financial System Stability
Theme 7: Operational Efficiency
Theme 8: Currency—The Next Generation of Bank Notes
Theme 9: Supporting the Research

Upon completion, the results of most research projects will be available on the Bank's website at Research & Publications.

Theme 1: Inflation Control Strategy

Policy issue:

One of the Bank's main responsibilities is to aim to keep CPI inflation at the midpoint of the inflation-control target range, as per the joint inflation-control agreement with the Government of Canada. This agreement is renewed periodically to take advantage of the experience and knowledge constantly accumulated at the Bank and elsewhere. In this context, the Bank maintains an on-going research program that seeks to shed light on the best way that monetary policy can contribute to the welfare of Canadians. This research addresses a variety of questions under three general topics. The first relates to the costs and benefits of alternative monetary arrangements: for example, what are the welfare implications of a lower targeted inflation rate, or of price-level targeting relative to inflation targeting? The second issue concerns optimal monetary policy under various conditions: for example, how should monetary policy be conducted when faced with uncertainty about the appropriate model of the inflation process, or when faced with the possibility of an asset price bubble? A third topic continues our investigation of wage and price determination in Canada.

Research questions:

Q1: How do the welfare implications of price-level targeting compare with those of inflation targeting?
Q2: What are the costs and benefits of a lower rate of targeted inflation?
Q3: How should monetary policy react under uncertainty?
Q4: What information can be extracted from a survey of wage setting behaviour of Canadian firms?

Theme 2: Analysing Major Global Developments and Their Potential Impact on Canada

Policy issue:

As an open economy, Canada has a strong interest in an international trade and financial system that operates effectively, facilitates the expansion of trade and international investment, and promotes adjustment among countries in response to shocks. A key challenge for monetary policy is to identify and understand the developments in the world economy that might affect in a major way, either directly or indirectly, economic activity and inflation in Canada.

Research questions:

Q1: What factors are contributing to large current account surpluses and deficits among major countries around the world and how might these imbalances be resolved? What role can the International Financial Institutions play in this process?
Q2: What role do fundamental forces play in determining the value of the Canadian dollar and how should monetary policy react to these developments?
Q3: What is the impact of the growth in East Asia and of other demand and supply factors on world commodity prices and on world prices of manufactured goods?
Q4: Has trade with labour-intensive Asian countries affected labour and capital income shares in Canada?
Q5: How well is the Canadian economy adjusting to relative price movements?

Theme 3: Productivity, Labour Supply, and Potential Output

Policy issue:

Improving our understanding of the evolution of trend productivity and trend labour supply underpins better estimation and projection of Canadian economic potential. In turn, short-run deviations from potential output may provide warning signals of inflationary or deflationary pressures.

Canada has a long-standing productivity gap relative to the United States and, with the slowing of Canadian productivity growth in recent years, this gap has widened. How much of the recent slowdown in Canadian labour productivity reflects shifts in trend productivity growth rates as opposed to cyclical developments? To what extent do cyclical factors also explain the recent widening of the Canada-U.S. productivity gap? What structural factors contribute to labour productivity growth in the long run? Which structural factors contribute to the shortfall of trend productivity growth in Canada relative to the United States and what are the prospects for renewed convergence on U.S. productivity growth? To what extent do reallocation effects and changes in capital composition affect aggregate productivity growth and are these effects important for explaining recent behaviour? How do the productivity gaps compare on a sectoral basis, particularly in the financial services sector?

Potential output depends on trends in the labour market as well as in productivity. Assuming stable participation rates, employment trends should be more predictable than productivity trends given demographic information on the age distribution of the population and information on population growth. Nevertheless, shifts in participation rates and hours can add uncertainty to predictions of trends relevant for constructing estimates of potential output.

Research questions:

Q1: What are the current trend growth rates of Canadian labour productivity, labour supply, and potential output and how are these growth rates likely to evolve?
Q2: What factors explain the historical behaviour of Canadian labour productivity, including differences between Canadian and U.S. productivity experiences?
Q3: What factors influence Canadian labour supply?
Q4: How does productivity in the financial services sector in Canada compare to that in the U.S.?

Theme 4: Asset Prices

Policy issue:

There is a growing body of research showing that asset price movements influence the monetary transmission mechanism. This is partly because they determine the value of wealth which is an important determinant of borrowing and spending. Asset price movements also affect the timing of economic agents' consumption and investment decisions by influencing their access to credit. In addition, the impact of an asset price movement reflecting a change in its fundamental determinants may differ from the impact of a movement away from fundamentals.

A purpose of our research on asset prices in 2006 will be to better understand how changes in asset prices affect the transmission mechanism of monetary policy in Canada.

Research questions:

Q1: To what extent can movements in house prices contribute to a better understanding of aggregate consumption dynamics?
Q2: To what extent can fluctuations in business' net worth contribute to a better understanding of aggregate investment dynamics?
Q3: How does the Canadian economy react to large deviations of asset prices from fundamentals?

Theme 5: Financial System Efficiency

Policy issue:

An efficient financial system is critically important to the effectiveness of monetary policy and our fiscal agency responsibilities, the long-run stability of the financial system, financial innovation, and economic growth. The Bank of Canada thus has a strong interest in promoting the efficiency of the Canadian financial system.

The specific factors that affect the efficiency of financial institutions, markets and infrastructure are not well understood. Information is an especially critical element to the efficient functioning of financial markets and institutions. Thus, a major thrust of our research agenda is to develop a better understanding of how asymmetric information inhibits financial system efficiency. Another major component of our research is to understand the drivers of liquidity in fixed income markets. A third part of our research agenda is to deepen our understanding of financial infrastructure, focused currently on gaining a better understanding of the elements that contribute to payment system efficiency. Overall, this research agenda is focused on identifying areas where the efficiency of the financial system in Canada can be improved without compromising the safety or integrity of the system.

Research questions:

Q1: What factors might be inhibiting the efficiency of the Canadian financial system and, therefore, productivity of the economy as a whole?
Q2: How might clearing and settlement systems in Canada operate more efficiently without compromising safety?
Q3: How does the productivity of Canadian banks compare to those in the U.S.?

Theme 6: Financial System Stability

Policy issue:

A stable financial system makes an important contribution to the welfare of all Canadians because it is able to absorb adverse domestic and international shocks, both real and financial. One goal of our financial stability research is to improve our capacity to monitor systemic risk, i.e., the risk that the financial system would become unstable. A related objective is to develop models that will allow us to test the financial system's capacity to absorb significant shocks.

Payment, clearing, and settlement systems underpin the financial system. It is essential that risks in these systems be managed effectively and that, in particular, systemic risk be controlled. The key clearing and settlement systems in Canada are well-protected against systemic risk and the Bank of Canada is responsible for the oversight of these key systems. Operational risk, that is the risk associated with operational disruptions of these systems, is also a concern for central banks, and research in this area will continue.

Research questions:

Q1: What are the best indicators and models to assess macro-financial risk to the Canadian financial system?
Q2: What is the best way to do macro-financial stress-testing in Canada?
Q3: What are the key risks in clearing and settlement systems and what is the best way to manage them?
Q4: How might operational risk be reduced even further in the Bank's payment and settlement operations?
Q5. What should the IMF's fundamental objectives be in promoting a well functioning, market-based international financial system?

Theme 7: Operational Efficiency

Policy issue:

The Bank strives to be efficient in all of its operations. Two areas of focus in 2006 will be increased efficiency in its role as fiscal agent for the Government of Canada and in the production and distribution of Canadian bank notes.

As fiscal agent for the Government of Canada, the Bank provides high-quality, effective, and efficient funds management services including the management of the Exchange Fund Account and the government's treasury and domestic debt. While the current system is operating well, the Bank is looking at a number of ways of offering these services in an even more efficient or cost minimizing manner.

One issue is the optimal structure of the government's debt and foreign reserves. Research will focus on enabling a more efficient management of the government's debt and foreign reserves.

In meeting the needs of Canada for secure bank notes, the Bank carries out a number of activities and makes decisions on a number of issues related to the design, production, and distribution of Canadian bank notes. Operational research will include a focus on the review, assessment, and improvement of the bank note distribution system.

Research questions:

Q1: What is the optimal structure of Government of Canada debt?
Q2: How can the Bank increase the cost effectiveness of foreign exchange reserve management?
Q3: How can the Bank improve the auction system for Government of Canada debt?
Q4: How can the Bank improve its ability to ensure the quality and authenticity of bank notes circulating in the distribution system?

Theme 8: Currency—The Next Generation of Bank Notes

Policy issue:

Following the successful launch of the Canadian Journey series of bank notes, we are turning our attention to the next generation of bank notes. The threat of advances in technology to make high-quality counterfeits will continue to rise and the Bank will respond on an ongoing basis by anticipating such developments and by monitoring, evaluating or potentially developing new materials and security features. While research will continue on shorter-term questions such as the durability of notes in circulation and measuring the effectiveness of bank note communication, the primary focus will be on a multi-year research program leading to the timely introduction of a new generation of bank notes in order to maintain their security, so that Canadians can use them with confidence.

The research required for this undertaking is broad. First, further theoretical and empirical research are needed to understand who uses bank notes, how they are used, and what is the future of bank notes compared to other means of payment – how they can play the most productive role possible within Canadian society. Second, technical research and development will expand to provide ongoing assessment of existing and emerging technologies available to counterfeiters of bank notes. Scientific research and development will contribute to the selection of future bank note materials and security features. Finally, policy and strategic research is required to address a number of issues that will arise as planning for the development of the next generation of bank notes begins.

The Bank has a strong reputation for collaborative research. Research and development will continue to be done with others when this approach improves the potential for success. Entities in Canada and internationally will also be sought out and encouraged to engage in research and technical development that we believe will deal with existing and emerging threats we have identified.

Research questions:

Q1: How are Canadian bank notes used and what is the likely evolution of bank notes relative to other payment methods?
Q2: What security features, materials, and technologies should be adapted or developed for possible inclusion in the next generation of bank notes?
Q3: How can the Bank improve the management of bank notes in circulation, including measuring their durability and the effectiveness of communication to deter counterfeiting?

Theme 9: Supporting Research

Improving Analytical Tools

Researchers at the Bank of Canada use a variety of models to examine policy issues from a number of perspectives, and therefore tool development is taking place on many fronts.

Rigorous macroeconomic models of the monetary transmission mechanism continue to be the most important item in our economists' tool kit, and so the lion's share of our tool development work is aimed at improving these models. Examples of models that are under development include: sticky-price dynamic stochastic general equilibrium models; two-sector general equilibrium models with both tradable and non-tradable goods; general equilibrium models with financial frictions; and, multi-country general equilibrium models.

Researchers are refining and expanding a new projection and policy analysis model TOTEM – a sticky-price dynamic stochastic general equilibrium model of the Canadian economy that has recently been operationalized.

They are also refining a new model of the US economy (MUSE) that has rich theoretic underpinnings and is sufficiently disaggregated to be used for a wide-range of policy relevant questions and has good forecasting performance.

The Bank will be developing a global economic model (GEM) to assess the effects of global shocks on major economic countries or regions and their impact on Canada.

In addition to structural general equilibrium models, the Bank continues to develop new reduced-form models for economic analysis and forecasting. Many of these models will include financial variables, including micro-financial data. These models are most often used to identify those variables that are useful indicators for monetary policy. Some of these models will also be used to help staff understand the nature and magnitude of the risks associated with the Staff Economic Projection.

The Bank is also expanding the range of financial models that it uses to conduct research and analysis into financial behaviours, including those of financial market participants, financial institutions, and clearing and settlement systems. Examples of new models under development include: a model of realized volatility across financial markets that can capture the linkages between many markets; models of credit risk and its relationship to macroeconomic variables; and models of participant behaviour in Canada's Large Value Payment System.

Models of the yield curve and its drivers are also being developed to aid in the management of the Government's debt structure and portfolio of foreign exchange reserves.

Better Financial Data

Researchers at the Bank of Canada (and elsewhere) use a variety of financial databases to examine policy issues from a number of perspectives. This is due not only to the different questions and approaches to them but also to incomplete, inconsistent, or unavailable financial data on Canada for the questions being posed. In addition, research and analysis is focusing much more on understanding and deriving information from disaggregated micro data. In response, the Bank has initiated a project to assess the extent to which gaps in financial data can be filled for Canadian businesses (financial and nonfinancial), households, financial markets, and payments, clearing, and settlement systems. Priority in filling these gaps will be given to those areas that the Bank has identified as critical for policy research and analysis.