A comparison of optimal policy rules prior to and during inflation targeting: empirical evidence from Bank of Canada

Abstract

We examine policy rules that are consistent with inflation targeting (IT) framework in a small macroeconomic model of the Canadian economy. We set up an optimal linear regulator problem and derive policy rules to compare the dynamics of pre-IT and IT eras. We find that while the optimal monetary policy rule in the pre-IT period is best described with a loss function that attaches equal weight to price stability, financial stability and output stability; the IT era is dominated by the price stability objective followed by the financial stability and output stability, consecutively. Moreover, we do not find an explicit role for exchange rate stability in the objective function of the Bank of Canada for both monetary policy eras. We, then, compare the properties of the derived optimal rules with those of an ad hoc Taylor rule for the IT period. In response to inflationary shocks, Taylor rule brings down inflation rates more quickly compared to the derived policy rules, but at the cost of a higher sacrifice ratio and more volatile interest rates.