Economic Modelling 46 (2015) 1126

Contents lists available at ScienceDirect

Economic Modelling
journal homepage: www.elsevier.com/locate/ecmod

Transmission of US monetary policy into the Canadian economy: A

structural cointegration analysis
S. Mahdi Barakchian
Graduate School of Management and Economics, Sharif University of Technology, Tehran, Iran

a r t i c l e

i n f o

Article history:
Accepted 20 October 2014
Available online xxxx
Keywords:
Macroeconomic modeling
Long-run structural VAR
Monetary policy shock
International transmission

a b s t r a c t
This paper estimates a two-country model comprising structural cointegrated models of Canada and the US.
Using persistence prole analysis, we nd that the Term Structure and a modied Fisher equation are maintained
in the US model, and, the Term Structure, Fisher equation and Interest Rate Parity are maintained in the Canadian
model. Then we use the model to examine the transmission of US monetary policy into the Canadian economy.
The results show that the responses of the Canadian macro variables to the US monetary policy shock are very
similar to the responses of the US macro variables to the same shock: after a contractionary US monetary policy
shock, output falls quickly and shows a U-shaped response, ination falls with a delay, short-term interest rate
jumps and then gradually declines and long-term interest rate increases for one year and then gradually declines.
Our results show that interest rate-path-through is the major mechanism by which US monetary policy shocks
are transmitted into the Canadian economy.
2014 Elsevier B.V. All rights reserved.

1. Introduction
It is often stated that when the US sneezes, the rest of the world
catches a cold. Because of strong economic connections between
Canada and the US, Canada is very likely to be inuenced by events in
the US even more seriously than the rest of the world. In particular,
the extent of US monetary policy spillover is a central question for
Canadian policy makers. Policy makers are also interested to know the
role and relevance of different cross-border transmission channels.
These are the issues we will address in this paper.
In order to model the Canadian economy, we follow the Global
Vector Autoregressive (GVAR) modeling strategy which allows for a
rich representation of the cross-country transmission of shocks; see
Pesaran et al. (2004) and Dees et al. (2007a), DdPS. The GVAR model
is constructed from country-specic vector error correction models in
which domestic and foreign variables interact contemporaneously. In
this paper, however, instead of modeling a large set of countries
on which the GVAR is founded, we develop a two-country model comprising a structural cointegrated VARX* for Canada and a structural
cointegrated VAR for the US. This decision is based on the following
reasons. First, the Canadian economy is dominated by the US economy
and direct effects of other countries on Canada are likely to be small.
We will discuss this issue further in Section 3. Second, data for many
(developing) countries is not very reliable. Also, for many countries
data is not available for more than two (or three) decades.

I'd like to thank M. Hashem Pesaran and an anonymous referee for their comments.
E-mail address: barakchian@sharif.edu.

http://dx.doi.org/10.1016/j.econmod.2014.10.036
0264-9993/ 2014 Elsevier B.V. All rights reserved.

In the two-country model, which is called a VECX* model, Canada is

modeled as a small open economy and the US, treated as rest of the
world for Canada, is modeled as a closed economy. Each country
model is estimated using the Structural Cointegrating VAR approach.
This approach tries to reconcile the economic theory and the statistical
features of the data in which, restrictions needed to identify cointegrating
relations are provided by economic theory; for more details, see Pesaran
and Shin (2002) and Pesaran et al. (2000).
Our study shows that the Term Structure and a modied Fisher
equation are maintained in the US model, and, the Term Structure,
Fisher equation and Interest Rate Parity are maintained in the Canadian
model. However, there is no strong empirical evidence in favor of the
Purchasing Power Parity hypothesis and a convergence relationship
between the US and Canadian outputs. An interesting result is that the
interest rate differential between the US and Canada is a major factor
in driving the Canadian macro variables.
By relaxing the coefcient of ination in the Fisher equation, we also
estimate a range of possible values for that coefcient. We nd that the
coefcient lies in the range [1.4,2.0] for the US and in the range [1.4,2.2]
for Canada though it is not signicantly different from 1 for the Canadian
model. These results are consistent with both tax-adjusted Fisher
hypothesis (Crowder, 1997, and Crowder and Hoffman, 1996) and
long run interest rate rule (Assenmacher-Wesche and Pesaran, 2009,
and Dees et al., 2007b).
Then we examine the transmission of US monetary policy shocks into
the Canadian economy using impulse response analyses conducted for
the VECX* model. In order to make a comparison, we also use a single
equation model to estimate the responses of the macroeconomic variables to the US monetary policy shock series constructed by Romer

12

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

and Romer (2004), who use a narrative approach based on the minutes
of the FOMC meetings to construct a series of US monetary policy shocks.
The results of the impulse response analysis show that the responses
of the Canadian macro variables to the US monetary policy shock are
similar to the responses of the US macro variables to the same shock:
after a contractionary US monetary policy shock, output falls quickly
and shows a U-shaped response, ination falls with a delay and nally
converges to the initial equlibrium, short-term interest rate jumps and
then gradually declines and long-term interest rate increases for one
year and then gradually declines. Our results also show that increasing
the number of lags in the VAR alleviates the price puzzle.
The major contributions of the paper are threefold. First, we
have spent much time on constructing the USCanada two country
model using the GVAR modeling strategy, and paid much attention to
every detail of the model such as selecting the variables, lags, and
cointegration ranks, specications of the long run relations, etc. This
well-constructed model enables us to answer the questions that the
paper is aimed to address: What are the short run and long run impacts
of US monetary policy on Canadian monetary policy? How does US monetary policy affect Canadian output and prices? Is US monetary policy
transmitted into the Canadian economy through the expenditureswitching-effect mechanism or the interest-rate-path-through mechanism? To our knowledge, this two-country model is new for Canada
and no other paper has yet investigated the impacts of US monetary
policy on the Canadian economy as detailed as this paper. Of course,
the two-country model is a powerful tool to conduct policy analysis for
issues other than those analyzed in the paper. Second, there is a dispute
in the literature regarding the impacts of US monetary policy on the
Canadian economy. We provide compelling evidences that interest ratepath-through is the most important mechanism by which US monetary
policy shocks are transmitted into the Canadian economy. Specically,
our estimations show that as soon as the Fed raises the US short term
interest rate by 100 basis points, the Bank of Canada follows the US by
raising the Canadian short term interest rate by 62 basis points. In addition, the Canadian short term interest rate converges to the US short
term interest rate in the long run reasonably fast. Third, using a wild bootstrap method to produce critical values for the overidentication test
developed for cointegration restrictions, when there is heteroskedasticity
in error terms, is another contribution of the paper.
The remainder of the paper is organized as follows. Section 2 reviews
the literature on cross-country transmission of US monetary policy.
Section 3 describes the two-country VECX* model. Section 4 presents
the empirical results. Section 5 examines the transmission of US monetary policy shocks to the Canadian economy using impulse response
functions. The last section concludes.
2. International transmission of US monetary policy
Does a monetary expansion in the US lead to a recession or a boom
in other countries? From a theoretical point of view, there is not a
conclusive answer to this question. MundellFlemingDurnbush
(MFD) model predicts that in the context of a oating exchange rate
regime, an expansionary US monetary shock leads to a fall in the foreign
output. This is due to the expenditure switching effect. Based on this
theory, an expansionary US monetary shock leads to a devaluation of
the US currency. Since prices are assumed to be sticky, or even xed in
the short run, the relative prices of US products will be decreased.
Hence, US products become more competitive and this will lead to an
improvement in the trade balance. As a result, the US output rises
while the foreign output falls. So expansionary US monetary policy has
a beggar-thy-neighbour effect. Since for the foreign country, imports
are cheaper now and therefore there is a substitution towards imports,
the depreciation of exchange rate leads to a fall in the foreign price level.
In the MFD model it is usually assumed that foreign interest rate is
exogenously set and therefore is invariant to the US monetary policy.
But if foreign monetary authority adjusts its monetary policy in

response to the US Fed's policy, then an expansionary shock to the US

monetary policy will induce foreign consumption and investment
which in turn has a positive effect on foreign output. In a similar mechanism, an expansionary shock to the US monetary policy may lead to a
fall not only in the US interest rate but in the foreign (long term real)
interest rate through, for example, no arbitrage condition. Then a
drop in the interest rates will induce world aggregate demand, which
increases the demands for both US and foreign goods, which in turn
leads to an increase in foreign output. This mechanism is supposed to
hold for the US monetary policy because of the dominant role of the
US in the world economy.
The inuential work of Eichenbaum and Evans (1995) is one of the
rst papers using the Structural VAR methodology to assess the effect
of US monetary policy shock on foreign variables. Their results show
that a contractionary US monetary sock leads to persistent, signicant
appreciations in US nominal and real exchange rates. This shock also
leads to a rise in US and foreign interest rates but the rate of increase
in foreign interest rates is smaller such that the spread between foreign
and US interest rates falls. Therefore, they conclude that there is a
signicant departure from uncovered interest parity in the short run
following a US monetary shock.
Kim and Roubini (2000) show that following a US monetary policy
contraction, exchange rates appreciate, foreign interest rates generally
rise, foreign prices increase in short term then converge to the initial
equilibrium, and foreign outputs rise rst and then fall in long term.
Faust et al. (2003) nd qualitatively similar results to Kim and
Roubini (2000) when studying the effects of US monetary policy on
Germany and the UK. However, counter to Kim and Roubini (2000),
the predominant response to a US monetary contraction is a foreign
output decline.
Kim (2001) shows that an expansionary US monetary shock has a
positive spillover effect over the non-US G-6 output. He argues that
this positive spillover occurs through the capital market mechanism
by reducing the world interest rate rather than through trade mechanism suggested by the MFD model. But the size of the positive effect
on foreign output is smaller than on US output. There is no signicant
effect of US monetary policy on foreign price level. He also shows that
there is not a strong evidence in favor of the endogeneity of non-US
monetary authorities reaction to the US monetary policy. This result
is in contrast to studies like Bluedorn and Bowdler (2011) and
Scrimgeour (2010), who show that a positive innovation to the Federal
Funds rate increases foreign short term interest rate, and they interpret
that as a sign that non-US monetary authorities follow the Fed's
monetary policy.
Holman and Neumann (2002) do not nd evidence to support the
claim that Canadian monetary policy follows US monetary policy.
They show that US money can explain only a small fraction of the
variation in Canadian money. The exchange rate appreciates in medium
term following an expansionary US monetary shock which can be
interpreted as the exchange rate puzzle. The effect of an expansionary
US monetary shock on Canadian output is positive in the long run but is
mixed in the short run.
Bluedorn and Bowdler (2011) examine the effects of US Monetary
policy shocks on the other G-7 countries. Using the Romer and
Romer's (2004) monetary policy shock series, they nd that direct interest rate linkages are an important channel in international business
cycle propagation. An increase in the US interest rate raises foreign
interest rates at short horizon but reduces it at long horizon. They also
nd that after a contractionary US monetary shock foreign countries
experience a recession and foreign prices fall, in some cases immediately
and in others with one or two years delay.
Scrimgeour (2010), studying the effects of US monetary policy on
output of four countries in the Americas, nds that foreign output falls
signicantly after a contractionary US monetary policy shock and the
response of foreign output is generally similar to the response of US
output. He therefore concludes that the results are inconsistent with

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

expenditure-switching theory and he argues that this is perhaps due

to the fact that foreign monetary authorities tend to follow the Fed's
policy.
In summary, there is not a consensus among empirical studies
regarding the effects of the international transmission of US monetary
policy shocks. However, majority of the studies support the interest
rate-path-through as the major channel of cross-country monetary
policy transmission rather than the expenditure switching effect,
and therefore their results are more consistent with a prosper-thyneighbour effect as opposed to a beggar-thy-neighbour effect.
3. Outline of the two-country model
The high dominance of the US economy over the Canadian economy
means that the US essentially serves the role of rest of the world to
Canada. This fact simplies the specication of foreign variables in a
Canadian model and most of the macroeconometric models developed
for Canada, e.g. NAOMI, M1-VECM, etc., include US variables as foreign
variables (see Ct et al., 2003). As Ct et al. (2003) indicate, since
shocks from Canada have little impact on the US it is generally acknowledged that US variables can be assumed exogenous with respect to the
Canadian economy; see also Cushman and Zha (1997). This strategy has
also been adopted by other papers, e.g. Canova (2005) and Mackowiak
(2007), which study the effects of the US economy on other small open
economies.
This is also consistent with the literature on the US economy;
Majority of studies, model the US as a closed economy; see, for example,
Anderson et al. (2002), Bernanke and Mihov (1998), Christiano et al.
(1996,1999) and Sims and Zha (2006) inter alia. This is the line which
will be followed in this research; we develop a two-country VECX*
model comprising the US which is modeled as a closed economy and
Canada which is modeled as a small open economy.
To construct the two-country model, rst a cointegrated VAR for the
US and a cointegrated VARX* for Canada are estimated. As noted earlier,
we use economic theory to provide restrictions needed to identify
cointegrating relations. The over-identifying restrictions implied by
the long-run theory relations are tested, and if not rejected, are then
embodied in the model. The result is a cointegrating VAR such that the
long-run relations are its steady-state solutions. Then the Canadian
and US models are combined to form a complete system, called a
VECX* model.
The structure of the two-country model enables us to consider many
different channels of transmission of shocks from the US to Canada.
These channels range from nancial markets, e.g. through crosscountry correlations of long term interest rates, to technology diffusion,
e.g. through output convergence relation.

13

show that including long term interest rate contributes substantially

to the forecast accuracy of output growth and ination for Canada and
the US.
In order to prevent having quadratic trends in the level of the
variables in the models of the US and Canada, deterministics are
treated according to case IV, as described in Pesaran et al. (2000),
in which, intercepts are unrestricted, but the trend coefcients are
restricted to lie in the cointegrating space. Hence, the US model can be
written as
X


 p1












i xti a0 ut ;
xt xt1 t1

i1

where xt is a m* 1 vector of endogenous variables. When the

rank of

0
the matrix * is r* b m*, * can be decomposed as

, where
* is a m* r* matrix of loading coefcients and * is a m* r* matrix
of cointegrating vectors.
3.2. Model for Canada
We estimate a cointegrated VARX* model for Canada over the period
1958Q12004Q2, where the endogenous variables, xt, are Canadian
short term interest rate (rst ), Canadian long term interest rate (rlt),
Canadian ination (pt), Canadian income per capita (yt), and Canadian
real exchange rate (ert ). ert is computed as ert = et pt + pt , where et
is the (log) Canadian currency per US dollar.2 For estimation, the
foreign variables, xt , are treated as weakly exogenous with respect to
the parameters of the Canadian model. The model for Canada can be
written as

xt zt1 t1 xt

p1
X

i zti a0 ut ;

i1

where xt is a m 1 vector of endogenous variables, xt is a m* 1 vector




0 0
e  1 vector, where z0t x0t ; xt and
of exogenous variables and zt is a m
e m m
. When there are r cointegrating relations, within xt or
m
between xt and xt , then can be decomposed as = , where
e  r matrix of
is a m r matrix of loading coefcients and is a m
cointegrating vectors.

2
In contrast to the VECMs developed for Canada in the literature (e.g. Hendry, 1995; Armour et al., 1996; Engert and Hendry, 1998; Adam and Hendry, 2000; Kasumovich, 1996,
money measures are not included in our VECX* model. The rationale behind our decision
is based on the three following reasons.

3.1. Model for the US

We estimate a cointegrated VAR for the US over the period 1958Q1
2004Q2, where the variables, xt , are US short term interest rate (r st ),



US long term interest rate rl

t , US ination (pt ), US income per capita
1
(yt ), and oil price (ot). All variables are treated as endogenous in the US
model. Long term interest rate is added to allow for the yield curve
relationship since macroeconomic variables and the yield curve are
mutually interdependent. Not only macro variables affect the yield
curve (Diebold et al., 2006), but the yield curve can also help to explain
changes in macro variables like output (Estrella and Mishkin, 1998). Our
study provides more support regarding the latter and it shows that the
error correction term corresponding to the yield curve has a signicant
negative effect on output growth. In addition, Pesaran et al. (2009)

See the Appendix A for more details on the description of the time series.

(i) In recent years, most of the models developed for monetary policy analysis assume that money only plays a passive role. In other words, they assume that money is supplied passively by the central and commercial banks to meet rms' and
households' demand and, therefore, it may be ignored; see e.g. McCallum and Nelson (1999) and Rotemberg and Woodford (1997). It has also been argued that
measures of past ination, economic activity and interest rates contain a great
deal of information embedded in monetary aggregates; see e.g. Gal (2006) and
Woodford (2006), and also the papers presented at the 4th ECB Conference
The role of money: money and monetary policy in the twenty rst century.
(ii) The relationship between money and other economic variables in Canada has not
been stable over time. This observation can be partly explained by the institutional changes and nancial innovations that have occurred in Canada, particularly
after the 1980s, and also the improvement in electronic nancial services. As a result, the ofcial measure of money, M1, does not measure the appropriate measure of narrow money over time; see e.g. Adam and Hendry (2000) and Aubry
and Nott (2000).
(iii) For most of the past four decades, monetary aggregates have played no special
role in conducting monetary policy by the Federal Reserve; for more details
see e.g. Bernanke and Mihov (1998) and Kahn and Benolkin (2007). It has also
been shown that monetary aggregates have negligible prediction power for US
ination; see, for example, Hale and Jord (2007) and Kahn and Benolkin (2007).

14

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

3.3. The VECX* model

The models of Canada and the US are combined to form a complete
econometric model, a VECX* in which, all variables will be endogenous.
The VAR representation of the VECX* model can be written as
zt

p
X

i zti a bt Hvt ;

i1

where


xt
e
e ;
e
e ; i 2; ; p1;
e
; 1 I
zt
1
i
i
i1
p
p1 ;
 xt







a0

0m
m

e





;
a


 ; b


;
a

0

0
0
m m











I


0
0

u
m
m m
i
m m ; H
e
t


; vt
i

Im
i
i 0m
m
ut

The covariance matrix = E(vtv t) can be freely estimated by the

^ v
^t v
^ 0t =T , when no restriction is imposed on the
e m
e matrix
m
t

covariance matrix. This VECX* model has 10 endogenous variables,

r + r* cointegrating relations, and 10-(r + r*) stochastic trends.
This model allows for a large degree of interdependence through two
different channels. First, through the direct effects of xt variables;
shocks to the US have considerable impacts on Canada. Second, through
^ which are expected to be small
the covariances between errors, ,
relative to the direct xt effects.
3.4. Economic theory of the long-run
The long-run equilibrium relations can be derived from different
theoretical approaches to macroeconometric modeling. Garratt et al.
(2003a and 2006, Ch. 4) use stock-ow equilibria, arbitrage conditions
and long-run solvency requirements. Dees et al. (2007b), DHPS, extends
the analysis of Garratt et al. to the cases where the long term interest
rate and equity prices are included in the model. Alternatively, Gal and
Monacelli (2005) derive the long run relations using inter-temporal
optimization conditions in a New-Keynesian DSGE model. Despite the
differences between the two approaches, they yield similar long run
relations; for more details, see Garratt et al. (2006, Ch. 4), and Pesaran
and Smith (2006).
In our two-country model, the US is modeled as a closed economy.
Hence, in light of the above-mentioned literature, two possible withincountry long run relations suggested by economic theory to hold in
the US model are the Term Structure (TS) and Fisher equation:

rt pt b2 2;t ;

Fisher :

l

rt rt b1 1;t ;

TS :

s

where i,t, i = 1, 2, is a mean zero stationary process.

But, Canada is modeled as a small open economy. Therefore, in
addition to the Term structure and Fisher equations, three possible
cross-country long run relations are also suggested by economic theory
to hold in the model of Canada, i.e. Interest Rate Parity (IRP), Output
Convergence (OC), and Purchasing Power Parity (PPP):
IRP :
OC :

PPP :

l
l
rt rt

b3 3;t ;

yt yt b4 4;t ;

et pt pt b5 5;t :

Although IRP is written here in terms of long term interest rate,

it could be written alternatively in terms of short term interest
rate. When building a structural cointegrating VECM for each country,
these long run relations will be incorporated into an otherwise unrestricted VAR model.
There is a sizable literature examining the validity of the abovementioned long run relations for the US and Canada. Studies like
Bradley and Lumpkin (1992), Campbell and Shiller (1987), Choi and
Wohar (1991), Engle and Granger (1987), Hall et al. (1992) and
Zhang (1993) nd a cointegrating relation between the yields of the
US bonds with different maturities which supports the Term Structure
relation for the US. Boothe (1991) and Siklos and Wohar (1996) provide
mixed support for existence of such a cointegrating relation for both
Canada and the US: in Siklos and Wohar (1996) the one-for-one relation
between the yields is generally accepted whereas in Boothe (1991) the
coefcient in the cointegrating relation is signicantly different from
1. Several studies have found a one-for-one cointegrating relationship
between Canadian and US interest rates which justies IRP; see, for
example, Boothe (1991) and Engert and Hendry (1998). But, the
evidence in support of PPP condition between Canada and the US is
rather weak; see, for instance, Johnson (1990), Turtle and Abeysebera
(1996) and Flynn and Boucher (1993).3 Similarly, the time series evidence has not been supportive of the output convergence hypothesis,
i.e. a one-for-one cointegrating relation between these two countries'
real income per capita; see for example, Bernard and Durlauf (1995).4
The Fisher equation will be discussed in more detail in Section 4.3.
4. Empirical results
Tables 7 to 10 in Appendix A show the results of the Augmented
DickeyFuller (ADF) and PhillipsPerron (PP) tests for the levels
and rst differences of the variables. These tests are calculated over
1958Q12004Q2. The results suggest that the null hypothesis that ert ; rst ;
l

o


rlt ; yt ; rs

t ; rt ; yt and pt contain a unit root cannot be rejected when the
unit root tests are applied to the level of the variables but is rejected
when the tests are applied to the rst difference of the variables.
The ADF test results for pt and pt are ambiguous. The unit root
hypothesis is rejected for low orders of augmentation when applied to
the rst differences of pt and pt , but it is not rejected for higher order
of augmentation. The PP test results for pt are doubtful too. The unit
root hypothesis is rejected for larger Bartlett windows used in the
computation of the PP statistics when applied to the rst differences
of pt , but it is not rejected for smaller windows. The Fisher equation
implies that the orders of integration of ination and interest rate are
the same. Although in economic literature, ination and interest rate
are usually supposed to be I(0) but regarding the results of unit root
tests for interest rate, which show that rst and rst are I(1), and the
ambiguous results for pt and pt , which show that pt and pt are
on the border of being I(1)/I(0), we decide to treat pt and pt as
I(1) series. Treating rst , rst , pt and pt as I(1) variables enables us to
represent the statistical properties of the series and at the same time
to consider the Fisher equation as a long-run relation in our model.
In view of the above results, from now on we assume that all the ten
variables in the VECX* model are I(1).
4.1. Lag order selection
Table 1 shows that the SIC selects 1 lag for both Canada and the US,
whereas the AIC favors 2 lags for Canada and 3 lags for the US. Actually
there is a trade off here; on the one hand, choosing low order of VAR
3
Most of the studies examining whether PPP holds between countries have been criticized for suffering from the size distortion bias arising from heteroskedasticity. Recently,
Su et al. (2014) have found that even when this problem is taken into account using a wild
bootstrap method, still there is a strong evidence against PPP.
4
In all the studies noted in this section, the long-run relations are treated individually.

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

Table 1
Lag order selection criteria.
US

Canada

Lag order

AIC

SIC

AIC

SIC

1
2
3
4

3542.5
3572.0
3581.2
3571.0

3486.2
3475.4
3444.3
3393.8

7504.1
7517.7
7501.3
7479.3

7310.9
7163.5
6986.0
6803.0

Notes: AIC is the Akaike information criterion and SIC the Schwarz information criterion.
The information criteria are computed using 186 observations from 1958Q1 to 2004Q2.
Intercept and trend are included in the estimations. Considering the nature of quarterly
data and the number of observations in each sample, we set the maximum lag order at 4.

leaves the residuals to be serially correlated. But on the other hand,

choosing high order of VAR implies a large number of parameters to
be estimated. In practice, two lags generally provide sufcient dynamics
in the model and it is seldom the case that a well-specied model needs
more than two lags; see Juselius (2007, p. 72) and Garratt et al. (2006,
Ch. 9). We will proceed from here with the lag length of two for both
models and leave a further discussion on lag order selection (and its
consequences for impulse response functions) to Section 5.1.
4.2. Cointegration rank
Table 2 presents the results of the trace and maximal eigenvalue
statistics with the critical values. Both the maximal eigenvalue and
trace tests favor r* = 2 for the US model. As we argued in Section 4,
macroeconomic theory also suggests that two long run relations,
i.e. the Term Structure and Fisher relations, hold in the US model.
Fig. 1 shows that the persistence proles of the Term Structure and
(modied) Fisher equation in the US model are very well behaved and
they quickly converge to zero after a system-wide shock. Therefore, it
seems that r* = 2 is appropriate for the US model.
The results of the cointegration rank tests for the model of Canada is
not as straightforward. The cointegration rank tests in a VECM with
weakly exogenous I(1) variables have been analyzed in both Harbo
et al. (1998) and Pesaran et al. (2000). In both of these studies, it is
assumed that the weakly exogenous variables, xt , are not cointegrated
among themselves. Based on this assumption the critical values are
simulated where the number of weakly exogenous variables is m* (m*
is the dimension of xt ). However, as we just showed, this assumption
does not hold in the model of Canada because two cointegrating relations exist among the ve variables in xt . For this case, the cointegration
test needs to be modied. But no formal statistical analysis has been yet
developed for this. Assenmacher-Wesche and Pesaran (2009) suggest
that in this case the effective number of weakly exogenous variables
used in the cointegration rank test should be equal to the number of
Table 2
Cointegration rank tests.
US

Canada

Rank

Trace

CV

-max

CV

0
1
2
3
4

149.5
62.5
33.4
16.1
4.1

82.8
59.1
39.3
23.0
10.5

87.0
29.1
17.2
12.0
4.1

35.0
29.1
23.1
17.1
10.5

Rank

Trace

CV5

CV3

-max

CV5

CV3

0
1
2
3
4

168.4
115.0
75.3
43.2
19.1

135.7
102.4
72.3
46.1
23.1

114.7
85.5
59.3
37.0
18.1

53.4
39.6
32.0
24.1
19.1

49.5
43.6
37.2
30.5
23.1

43.9
38.0
31.8
25.2
18.1

Note: The sample period is 1958Q1 to 2004Q2. CV5 (CV3) denotes the 90% critical value
that assumes the presence of ve (three) exogenous I(1) variables. The order of the underlying VAR is 2 and the model contains unrestricted intercept and restricted trend
coefcients.

15

weakly exogenous variables, m*, minus the number of cointegration

relations among the exogenous variables, r*. Hence, we report two
sets of critical values in Table 2, CV5 and CV3 which assume the
presence of ve (m* = 5) and three (m* r* = 3) exogenous
I(1) variables, respectively. Based on CV5, the trace test indicates r =
3 and the maximal eigenvalue test indicates r = 1. Based on CV3, the
trace test rejects even r = 4 in favor of r = 5 but the maximal eigenvalue
test indicates r = 3.
Economic theory suggests ve long run relations, i.e. PPP, IRP, OC,
Fisher and TS, to hold in the model of Canada. However, we need rst
to investigate the properties of these long run relations using persistence prole analysis. We impose all the ve long run relations (r =
5) on the model of Canada and then combine the Canadian model
with the US model, where TS and (modied) Fisher equation are
imposed on the US model, to obtain a complete VECX* model. Needless
to say that we need a complete model to derive persistence proles. This
analysis shows that the persistence proles of the Canadian Term
Structure, Canadian Fisher equation and Interest Rate Parity die out
fast whereas the persistence proles of the Purchasing Power Parity
and Output Convergence are very persistent (see Fig. 5 in Appendix
A).5,6 Based on these observations we believe that r = 3 where the
Term Structure, Interest Rate Parity and Fisher equation are imposed
on the model of Canada is the most appropriate. In Section 4 below
we will test the over-identifying restrictions implied by these three
long run relations. The result that Canada has three cointegrating
relations is consistent with the results of other studies such as DdPS.

4.3. Fisher equation

The empirical evidence on the long run Fisher parity is mixed. Using
the Johansen technique, Dutt and Ghosh (1995) nd no evidence of the
Fisher parity over the post-war period (1960Q11993Q4) for Canada.
Using the EngleGranger technique, Atkins (1989) nds evidence in
favor of a long run relation between ination and the nominal interest
rate for the US over the period 19531981. MacDonald and Murphy
(1989) use the same technique and nd such a long run relation for
the US and Canada over the period 19551986 only when the sample
is split according to exchange rate regime. Atkins and Coe (2002) use
the ARDL technique and nd results consistent with the one-for-one
Fisher equation for the US and Canada over the period 1953:01
1999:12. In a recent study, Everaert (2014) shows that the impact of
ination on the nominal interest rate is not signicantly different from
one in the sample of OECD countries (including the US and Canada)
which supports for the Fisher effect, when controlling for an unobserved
non-stationary common factor in estimating the Fisher equation.
DHPS show that the estimate of the ination coefcient in the Fisher
equation for the US is 2.06 whereas for Canada is not signicantly different from 1. They interpret the value of the ination coefcient as the
importance of the ination term in the central bank feedback rule and
argue that the coefcient should be greater than one if the central
bank wants to ensure that the real interest rates move in the right
direction to stabilize output, in accordance with the Taylor principle.
The modied Fisher equation is then called a long run interest rate
rule (Assenmacher-Wesche and Pesaran, 2009).

5
In Fig. 5 we only report the persistence proles of PPP and OC. The results for the persistence proles of the other long run relations are almost identical to Fig. 1. We also investigate the properties of the persistence proles where r = 4 (5 models; TS, Fisher, IRP and
one of PPP or OC are imposed on the Canadian model) and r = 1 (5 models; each of the the
TS, Fisher, IRP, PPP and OC is imposed separately on the Canadian model). In all these
cases, the persistence proles of PPP and OC are almost identical to Fig. 5 and they are very
persistent.
6
Since the real exchange rate shows a small trend over part of the period 1958Q1
2004Q2, we also examined the PPP where co-trending is not imposed on the cointegrating
relation. The persistence prole of the PPP was still persistent although the convergence
towards zero was faster.

16

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

Canada TS

Canada IRP
1.6

1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0

1.4
1.2
1
0.8
0.6
0.4
0.2
0
0

12

16

20

24

28

32

36

Canada Fisher

12

16

20

24

28

32

36

28

32

36

US Modified Fisher

1.2

1.2

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0
0

12

16

20

24

28

32

36

24

28

32

36

12

16

20

24

US TS
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
0

12

16

20

Notes: The solid line is the persistence profile generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 1. Persistence proles of the effect of a system-wide shock to the cointegrating relations. Notes: The solid line is the persistence prole generated from the VECX* model and the dashed
lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.

Another interpretation for the modied Fisher relationship is

provided by the tax-adjusted Fisher hypothesis; see, for example,
Crowder and Hoffman (1996) and Crowder (1997). When nominal
interest income is taxed, the after-tax Fisher effect implies that nominal
interest rate will adjust by more than one-for-one with movements in
ination. Using the Johansen technique, Crowder and Hoffman (1996)
estimate the coefcient to be about 1.4 for the US over the period
1952Q11991Q4 in a bivariate system. Crowder (1997) uses the same
methodology and estimates the coefcient to be between 1.51 and
1.89 for Canada over the period 1960Q11991Q4. Atkins and Coe's
(2002) results do not support the tax-adjusted Fisher effect for Canada
and provide mixed evidence for the US over the period 1953:01
1999:12.
We follow the above literature and relax the coefcient of ination
in the Fisher equation to see if it is signicantly different from 1 in the
models of the US and Canada. The modied Fisher equation can be
written as
s

rt pt b20 2;t :

The estimates of * and , namely the coefcient of ination in

the Fisher equations of the US and Canadian models, are 1:9536 and
0:5068

1:7146 , respectively (standard errors are in parenthesis). These esti0:8239

mates are obtained where TS and modied Fisher are imposed on the
US model and TS, IRP and modied Fisher are imposed on the Canadian

model. It is clear that the coefcient of ination is signicantly larger

than 1 for the US and not signicantly different from 1 for Canada.
We examine the sensitivity of the results to the lag structure
adopted for our VAR models. We consider the lag orders between 1
and 8 for both the US and Canadian models and estimate * and for
each lag order. The results, reported in Table 3, show that * lies
between 1.4 and 2.0 and lies between 1.4 and 2.2. The coefcient in
the Canadian model is never signicantly different from 1 whereas it
is signicantly larger than 1 in the US model for most of the lag
structures.
Based on the DHPS' interpretation, it seems that the Fed has overreacted to ination persistently, so that the US interest rate has been
raised more than ination in the long run whereas the over-reaction
perhaps is not as profound in the case of the Bank of Canada. But to
what extent the Fed's reaction to ination has been stronger than that
of the Bank of Canada is an issue for further research. The estimates
presented here clearly show a lack of precision.
We proceed with the results obtained for our model with two lags:
The modied Fisher equation with * = 1.9536 is imposed on the US
model and the Fisher equation, with one-for-one relation between
interest rate and ination, is imposed on the Canadian model.
4.4. Over-identifying restriction test
Based on the results obtained in the previous sections, we impose
the Term Structure and the modied Fisher equation on the US model
and the Term Structure, Interest Rate Parity and Fisher equation on

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

US short term interest rate

17

US long term interest rate

0.0025

0.0018
0.0016
0.0014
0.0012
0.001

0.002
0.0015

0.0008
0.0006
0.0004
0.0002
0

0.001
0.0005
0
0

12

16

20

24

28

12

US inflation

16

20

24

28

US output
0.004

0.002
0.0018
0.0016
0.0014
0.0012
0.001
0.0008
0.0006
0.0004
0.0002
0

0.002
0
-0.002

12

16

20

24

28

-0.004
-0.006
-0.008
-0.01
0

12

16

20

24

28

-0.012

Canadian short term interest rate

Canadian long term interest rate

0.0018
0.0016

0.0025

0.0014
0.002

0.0012

0.0015

0.001
0.0008

0.001

0.0006
0.0004

0.0005

0.0002

0
0

12

16

20

24

28

Canadian inflation

12

16

20

24

28

Canadian output
0.004

0.002

0.002

0.0015

0
0.001

12

16

20

24

28

-0.002
0.0005
-0.004
0
0

12

16

20

24

28

-0.0005

-0.006
-0.008

Notes: The solid line is the impulse responses generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 2. Impulse responses to a US monetary policy shock obtained from the VECX* model with two lags. Notes: The solid line is the impulse responses generated from the VECX* model and
the dashed lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.

the Canadian model. This amounts to 7 and 24 over-identifying restrictions for the models of the US and Canada, respectively. The Likelihood
Ratio (LR) statistic for over-identifying restrictions is reported in
Table 5. The LR test is asymptotically distributed by 2(q), where q is
the number of over-identifying restrictions (Pesaran and Shin, 2002).
However, in small samples, this test tends to over-reject (Garratt et al.,
2003). Therefore, we use bootstrap method to generate the critical
values.
4.4.1. Heteroskedasticity
Several studies have recently suggested that over the past two
decades, i.e. the so-called great moderation period, the variances of
the shocks driving macroeconomic and nancial time series have
changed and, in particular, have shown a general decline; see, for

instance, Busetti and Taylor (2003), Kim and Nelson (1999) and Koop
and Potter (2000). Cavaliere et al. (2010) argue that in the context of
time-varying volatility the wild bootstrap scheme is required rather
than the standard residual resampling bootstrap scheme proposed in
the literature (for instance, in Li and Maddala, 1996). That is because
the wild bootstrap replicates the pattern of heteroskedasticity present
in the original shocks.
When we examine the residuals of the error correction equations of
the US and Canadian models, we observe that the residuals of the output
equations in both countries show a clear decline in volatility over the past
two decades. Apart from the changes in volatility due to the great moderation, some other changes in volatility of the residuals can also be
identied. For example, the volatility of the residuals of the oil price
equation markedly increases from the early 1970s (rst oil price shock),

18

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

US short term interest rate

US long term interest rate

0.002

0.001

0.0015

0.0008
0.0006

0.001

0.0004
0.0005

0.0002

0
0

12

16

20

24

28

-0.0005

0
-0.0002 0

12

16

20

24

28

-0.0004

-0.001

-0.0006

US inflation

US output

0.0015

0.004

0.001

0.002

0.0005

-0.002

0
0

12

16

20

24

12

16

20

24

28

28

-0.0005

-0.004

-0.001

-0.006

-0.0015

-0.008

Canadian short term interest rate

Canadian long term interest rate

0.001

0.002

0.0008

0.0015

0.0006
0.0004

0.001

0.0002
0.0005

0
0

12

16

20

24

28

-0.0002

-0.0005

-0.0004

-0.001

-0.0006

Canadian inflation
0.004

0.001

0.002

0.0005

-0.002

0
4

12

16

20

24

12

16

20

24

28

Canadian output

0.0015

12

16

20

24

28

28

-0.0005

-0.004

-0.001

-0.006

-0.0015

-0.008

Notes: The solid line is the impulse responses generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 3. Impulse responses to a US monetary policy shock obtained from the VECX* model with eight lags. Notes: The solid line is the impulse responses generated from the VECX* model and
the dashed lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.

and the volatility of the residuals of the US short and long term interest
rates rises over the period 19781982 (the Volcker shock period).
Table 4 presents the results of heteroskedasticity test for the
residuals of the error correction equations. The null hypothesis of
homoskedasticity is rejected for ve equations at 1% and for two
equations at 10% signicance levels.
Therefore, we employ the wild bootstrap procedure with the bootstrap residuals generated according to the technique proposed in
Cavaliere et al. (2010). See Appendix A for a description of the bootstrap
procedure.
To our knowledge, no one has yet investigated the statistical properties of the wild bootstrap scheme for the over-identifying restrictions
test. The wild bootstrap has not also been used in any empirical study
to compute the critical values of the over-identifying restrictions test.

Hence, in order to compare between the results of the standard and

wild bootstrap schemes, we present the CVs generated by both schemes
in Table 5.
The CVs here are generated with 1000 replications. The results show
that the wild bootstrap generates wider condence intervals than the
standard bootstrap: the over-identifying restrictions of the US model
are not rejected at 1% signicance level using the wild bootstrap but
are rejected using the standard bootstrap; the over-identifying restrictions of the Canadian model are not rejected at 10% and 5% signicance
levels when the wild and standard bootstraps are used, respectively.
Due to the heteroskedasticity present in the residuals, we use the
CVs generated by the wild bootstrap and conclude that the overidentifying restrictions are not rejected in the models of Canada and
the US, i.e. the Term Structure and modied Fisher equation are

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

US short term interest rate

19

US long term interest rate

1.5
0.5
1
0.5

-0.5

0
0

12

24

36

48

60

72

84

12

24

36

48

60

72

84

-0.5
-1
-1
-1.5

-1.5
US inflation

US output

0.03

0.003

0.02

0.002

0.01
0.001

0
-0.01 0

0
0

12

24

36

48

60

72

84

12

24

36

48

60

72

84

-0.02

-0.001

-0.03

-0.002

-0.04
-0.003

-0.05

-0.004

-0.06

Canadian short term interest rate

Canadian long term interest rate

1
0.8

1.5

0.6

0.4
0.5

0.2

0
-0.5

12

24

36

48

60

72

84

0
-0.2 0

12

24

36

48

60

72

84

-0.4

-1

-0.6

-1.5

-0.8

-2

-1

Canadian inflation

0.003

Canadian output

0.01
0

0.002

-0.01

0.001

12

24

36

48

60

72

84

-0.02

0
0

12

24

36

48

60

72

84

-0.001

-0.03
-0.04

-0.002

-0.05

-0.003

-0.06

-0.004

-0.07

Notes: The solid line is the impulse responses generated from the single equation model and the dashed lines are the
90% confidence bands produced by Monte Carlo methods (500 replications) following the methodology in Romer and
Romer (2004, footnote 17).
Fig. 4. Impulse responses to the Romer & Romer shock obtained from a single equation model. Notes: The solid line is the impulse responses generated from the single equation model and
the dashed lines are the 90% condence bands produced by Monte Carlo methods (500 replications) following the methodology in Romer and Romer (2004, footnote 17).

maintained in the model of the US and the Term structure, Fisher equation and Interest Rate Parity are maintained in the model of Canada.
Fig. 1 shows that the persistence proles of all ve long run relations
in the VECX* model die out very fast after a system-wide shock hits
the cointegrating relations. The half life of the shocks ranges from only
one quarter for the US modied Fisher equation to six quarters for the
Canadian Term Structure relation. This conrms that the theoretic
long run relations are empirically valid.
4.5. Error Correction Equations of the Canadian Model
The estimates of the reduced form error correction equations of the
Canadian model with a number of diagnostic statistics are reported in

Table 6. The adjusted R2 of the different equations (except the real

exchange rate) is quite reasonable; it ranges from 0.34 for the output
to 0.75 for the long term interest rate. Overall, the diagnostic tests
indicate that the model performs well; The test for functional form is
rejected for none of the equations and the test for serial correlation is
rejected only for the ination equation. The test for normality, however,
is rejected for all equations except for the short term interest rate. The
error correction equations reveal some interesting results:
First, the only three variables which are signicant (at 10% level) in
the real exchange rate equation are the IRP term, and the Canadian
and US short term interest rates. The coefcients of these variables
show that raising Canadian interest rate relative to US interest rate
will appreciate the Canadian currency (in real terms), as to be expected.

20

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

Canada OC

Canada PPP

1.6

1.6

1.4

1.4

1.2

1.2

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

0
0

12

16

20

24

28

32

36

12

16

20

24

28

32

36

Notes: The solid line is the persistence profile generated from the VECX* model and the dashed lines are
the 90% confidence bands derived from 500 iterations of the wild bootstrap procedure.
Fig. 5. Persistence proles of the effect of a system-wide shock to the cointegrating relations. Notes: The solid line is the persistence prole generated from the VECX* model and the dashed
lines are the 90% condence bands derived from 500 iterations of the wild bootstrap procedure.

Second, the effect of oil price changes in all equations is very small
and mostly insignicant. Its effect on output is signicantly positive,
though very small. This observation is consistent with other studies
which nd oil price level to be almost neutral for the Canadian economy
(see Bashar et al., 2013, and IMF, 2005).
Third, in the output equation, the TS term is signicant (at 5% level).
It shows that raising short term interest rate relative to long term
interest rate has a considerable signicant negative effect on output
which is consistent with studies like Estrella and Mishkin (1998).
Fourth, in all the equations, the analogous US variable (at time t) is
highly signicant (at 1% level). The sign of the coefcient of the US
variable is positive and its size is considerable. In particular, the coefcient of rlt
in the equation of the Canadian long term interest rate
(rlt), is 0.875, which shows that 1% increase in the US long term interest
rate raises the Canadian long term interest rate by 0.9% within the
quarter. This result demonstrates the strong and quick effect of the US
economy's uctuations on the Canadian economy.
Fifth, the IRP error correction term, ^3;t1 , enters signicantly in all
equations except the ination equation. The sign of ^3;t1 in all these
equations is economically meaningful. This interesting result underlines
the fact that the US monetary policy drives the Canadian economy via
interest rate path-through mechanism.
Sixth, in the short term interest rate equation, only ^3;t1 and rst
are signicant at 5% signicance level.7 Therefore, we can present the
short term interest rate equation as:
s
s

rt 0:213 ^3;t1 0:622 rt u2t :
0:093

0:091

10

This equation shows that the Canadian monetary policy is extremely

inuenced by the US monetary policy. Based on this equation, as soon as
the Fed raises the US short term interest rate by 100 basis points, the
Bank of Canada follows the US by raising the Canadian short term
interest rate by 62 basis points. Moreover, the signicance of ^3;t1
ensures that the Canadian short term interest rate converges to the US
short term interest rate in the long run reasonably fast. When we drop
the US interest rates from the VARX* model of Canada, the adjusted R2
drops from 0.58 to 0.30 for the Canadian short term interest rate equation (It drops dramatically from 0.75 to 0.14 for the Canadian long term
interest rate.) This again emphasizes the inimitable role of US monetary
policy in shaping Canadian monetary policy.
As it is clear from Eq. (10) and also from the strong correlation
between the Canadian and US short term interest rates, the Bank of
7
The coefcient of the exchange rate in the interest rate equation is insignicant. Although the exchange rate is an important part of the transmission mechanism in shaping
monetary policy, measuring the response of the monetary policy tool to the exchange rate
is problematic. This is due to the simultaneous response of the exchange rate to monetary
policy changes. See, for example, Demir (2014) on how to identify the exchange rate's effect on monetary policy using high-frequency data.

Canada's strategy generally involves moving its interest rate in line

with US interest rate. This strategy has been at the center of debates
among Canadian policy makers. For example, in one of the sessions of
the Standing Committee of Finance in the Parliament of Canada at
May 16, 2000, members of the parliament challenged Governor of the
Bank of Canada for his monetary policy:8
This afternoon, the American federal bank, in view of the overheating
in the U.S., is getting ready to raise the American interest rate by about
half a point. What does the Bank of Canada plan to do? Does it simply
intend to increase the Canadian interest rates by half a point too, the
way it usually does, because, in my opinion, the Canadian monetary
policy is not autonomous .
[Yvan Loubier, MP]

In Canada, you must always look at what is happening in the U.S.

because this country is our biggest partner for foreign trade. when
the federal reserve increases its interest rates, this is a very important
piece of information for us. Sometimes we follow the U.S., sometimes
we decide not to follow .
[Gordon Thiessen, Governor of the Bank of Canada]

In the debate about the independence of Canadian policy, most of the

experts agree that, if the U.S. Federal Reserve raises its short-term interest rates by half a point, or 50 basis points, it is quite possible, indeed
almost certain, that the Bank of Canada will keep step by deciding on
an increase of 25 or 50 basis points. This is a trend that has been
observed for several years and it raises the entire question of the
independence of Canada's monetary policy in relation to U.S. monetary
policy.9
[Richard Marceau, MP]
As we see in the next section, the impulse response functions
also provide support for interest-rate-path-through mechanism via
presenting the time prole of the response of the Canadian monetary
authority to US monetary policy shock.

8
See the website of the parliament of Canada at http://www2.parl.gc.ca/
HousePublications/Publication.aspx?DocId=1040348.
&Language = E&Mode = 1&Parl = 36&Ses = 2.
9
As another example, John Crow (2002, pp. 152153), Governor of the Bank of Canada
19871994, discusses this strategy in the case of the Canadian response to the Volker disination: At the start of the 1980s, the Bank's monetary policy was to all intents forced by
events outside our borders - namely, the great America disination led by the Federal Reserve's
Paul Volcker. Confronted itself with the fallout from the U.S. decision to confront ination,
the Bank of Canada decided to try to hang on to the U.S. dollar exchange value for our currency.
This meant, in practice, at least matching U.S. rate increases.

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

Table 3
Estimate of the coefcient of ination in the Fisher equation.

Table 5
Long run over-identifying restrictions test.

Lag order

US (*)

1:6418

1:9536

1:8055

1:4243

1:5609

Canada ()

1:4490

1:7146

1:5220

2:2003

1:6312

0:3772

0:5893

0:5068

0:4805

0:8239

0:2901

0:9294

1:7938

0:3265

0:6089

Note: The US cointegrated model is estimated with two long run relations (TS and
modied Fisher) and the Canadian cointegrated model is estimated with three long run
relations (TS, modied Fisher and IRP). Critical value for a one tailed t test at 5%
signicance level is 1.645. * denotes signicance at 5% level. The sample period is
1958Q1 to 2004Q2.

5. Impulse Response Functions (IRF)

The literature of the identication of US monetary policy shocks
is founded on the idea that US monetary policy instruments are not
exogenous with respect to other US macro variables and therefore can
not be used directly to estimate the effects of monetary policy on
macro variables. This logic can be extended to the case of crosscountry effects of US monetary policy. Although in reality the US
monetary policy instrument (US short-term interest rate) may not
respond directly to movements in the Canadian economy but the US
and Canadian economies may be affected by common shocks. In this
case there is an endogenous component in the US monetary policy
instrument with respect to Canadian macroeconomic variables and it
cannot be used as an exogenous variable to estimate the effects of US
monetary policy on the Canadian economy. Therefore, we need to
decompose the US monetary policy instrument into systematic and
shock components and use the shock component, as an exogenous
variable with respect to the Canadian macroeconomic variables, to
estimate the effects of US monetary policy on the Canadian economy.
It is widely accepted that the Fed does not generally target exchange
rates or foreign variables directly; see for example Meulendyke (1998).
Therefore, in order to identify US monetary policy shock, we assume
that the US short term interest rate is not adjusted in response to
idiosyncratic foreign shocks. This is similar to the assumption adopted
by studies like Scrimgeour (2010). This assumption implies that if a
measure of monetary shock is exogenous to US variables, it is also
exogenous to Canadian variables. This assumption justies the use
of the US monetary policy shock identied in our closed US model to
estimate the effects of the US shock on Canadian variables.
Christiano et al. (1999) show that to identify the effects of monetary
policy shocks on other variables in an exactly-identied short run
structure, only specifying the place of monetary policy variable in the
vector of variables is crucial and the position of the other variables
relative to each other is not important. Hence, the IRFs are invariant to
the ordering of the Canadian variables in the VECX* model, so long as
the contemporaneous correlations of these variables are left unrestricted.
In summary, we only need to identify a short-run structure for the US
variables.

Table 4
Heteroskedasticity test.
US

Canada

21

rst

rlt

pt

yt

pot

0.366

17.798***

9.802***

3.489*

19.351***

ert

rst

rlt

pt

yt

0.540

3.647*

8.592***

10.139***

0.832

Notes: The US cointegrated model is estimated with two long run relations (TS and
modied Fisher) and the Canadian cointegrated model is estimated with three long run
relations (TS, Fisher and IRP). * ,** and *** denote signicance at the 10, 5, and 1% levels.
Critical values of 2(1) for 10, 5 and 1% signicance levels are 2.706, 3.841 and 6.635,
respectively. The sample period is 1958Q1 to 2004Q2.

US
Canada

LR statistic

Bootstrap scheme

CV 90%

CV 95%

CV 99%

33.65

24

61.42

Standard
Wild
Standard
Wild

21.27
25.57
59.32
63.82

24.57
30.39
64.29
69.30

31.68
43.16
73.46
80.90

Note: The US cointegrated model is estimated with two long run relations (TS and
modied Fisher) and the Canadian cointegrated model is estimated with three long run
relations (TS, Fisher and IRP). The critical values are simulated using both the standard
and wild bootstrap schemes. The sample period is 1958Q1 to 2004Q2. # denotes the
number of over-identifying restrictions.

We adopt an structure which is similar to the recursive ordering

suggested by Christiano et al. (1996,1999) to identify US monetary
policy shock in the closed US cointegrated VAR model. Based on this
structure, macro variables respond to the shock only with a lag whereas
nancial variables respond instantaneously. Also, monetary authority
reacts to oil price, as an information variable of inationary expectations,
contemporaneously. Therefore the variables in the US model are
ordered as: output, ination, oil price, short term interest rate and long
term interest rate. See Appendix A for the derivation of the IRF for the
VECX* model.10
Fig. 2 shows that a contractionary US monetary policy shock is
associated with a signicant quick rise in the US ination and short
term interest rate which is followed by a moderate decline. The
response of the US ination and short term interest rate remain signicantly positive over the horizon of 30 quarters. This is the well-known
price puzzle which will be investigated further in the next section.
The US long term interest rate gradually increases and the US output
rst rises, though not signicantly, and then falls. The response of the
US output becomes negative (though not signicant) after three
quarters and it becomes signicantly negative after one year and a
half. The gures show that the IRFs of the Canadian variables are very
similar to the IRFs of the US variables. However, although the Canadian
ination rises in response to a contractionary US monetary policy shock,
but the shape of the response is different from that of the US ination.
Besides, the negative response of the Canadian output never becomes
signicant.

5.1. Sensitivity of the Impulse Response Functions to the Lag Structure

The presence of the price puzzle in the IRFs indicates that either the
US monetary policy shock derived from the model is not sufciently
purged of the endogenous movements of interest rate originated from
response to conditions of the economy, or the model does not allow
the monetary shock to be passed on completely into the economy, or
a combination of both of them. There are several factors which can
explain either of the above possibilities. One factor, for example, is the
omitted variables problem. If the variables which will be considered
by the Fed when setting monetary policy is not included in the reaction
function, it will bias the shocks and consequently the IRFs; see, for
example, Christiano et al. (1999), and Sims and Zha (2006), for the
role of commodity prices in resolving the price puzzle. Similarly, if
the variables which are critical in transmitting monetary policy into
the economy are not included in the model, it will create another source
of bias for the IRFs. But, in this section we would like to focus on another
factor which could explain the price puzzle observed and that is the
choice of lag order.

10
All the estimations, construction of the VECX* model, and generation of the persistence proles and impulse response functions were done using the GAUSS software.

22

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

Table 6
Error correction equations of the Canadian model.
Equation

ert

rst

rlt

2pt

yt

^
1;t1

0:217

0:003

0:041

0:199

0:462

^
2;t1

0:331

0:031

0:008

0:171

0:037

^
3;t1

2:513

0:213

0:113

0:193

1:110

ert 1

0:043

0:009

0:001

0:033

0:019

rst 1

3:028

0:078

0:115

0:205

0:432

rlt 1

0:337

0:046

0:073

0:096

0:418

2pt 1

0:319

0:046

0:010

0:295

0:093

yt 1

0:104

0:014

0:005

0:039

0:085

rst
1

2:627

0:167

0:078

0:435

0:483

rlt 1

2:066

0:010

0:045

0:026

1:333

2pt 1

0:109

0:023

0:002

0:232

0:255

yt 1

0:158

0:016

0:010

0:028

0:181

pot 1

0:000

0:001

0:001

0:005

0:004

0:592

0:284

1:367

0:077

1:233

2:942
0:388

0:233

1:580

3:152
0:547

0:238
0:015

0:040
0:019

0:093

0:005
0:084

0:200

0:026

0:016
0:107
0:214
0:037

0:016

0:001

0:016

0:008

0:037

0:002

0:034

0:080
0:011

0:006

0:043

0:086
0:015
0:006

0:000

0:112

0:054

0:259

0:015

0:234

0:557

0:074

0:044

0:299

0:597

0:104
0:045

0:003

0:194

0:093

0:447

0:025
0:403
0:963
0:127

0:076

0:517

1:031
0:179

0:078

0:005

rst

1:629

0:622

0:004

0:216

0:113

rlt

2:460

0:262

0:875

0:195

1:047

2pt

0:291

0:042

0:015

0:468

0:144

yt

0:282

0:020

0:000

0:090

0:335

pot

0:019

0:002

0:001

0:000

0:010

R
SC : 2(1)
FF : 2(1)
N : 2(2)
HS : 2(1)

1:339
1:992
0:520

0:215
0:014

0:091

0:135

0:035
0:015

0:001

0:037

0:054

0:014
0:006

0:000

0:254
0:377

0:099

0:041

0:003

0:438
0:652

0:170

0:070

0:005

0.039

0.576

0.753

0.338

0.341

0.575
0.104
20.99
0.540

1.582
1.003
2.003
3.647

.019
.951
13.46
8.592

4.231
2.911
10.62
10.139

1.744
0.206
7.83
0.832

Note: The error correction terms ^1;t1 ; ^2;t1 and 3;t1, correspond to the Term Structure,
Fisher equation and Interest Rate Parity, respectively. , and denote signicance
at the 10, 5, and 1% levels. SC is a test for serial correlation, FF a test for functional form, N a
test for normality and HS a test for heteroscedasticity. Critical values are 3.84 for 2(1) and
5.99 for 2(2). The sample period is 1958Q1 to 2004Q2.

It is well know that the lag order selected for a VAR model can
affect the dynamic properties of impulse responses and can even change
the interpretation of impulse response estimates of a VAR; see
e.g. Hamilton and Herrera (2004) and Kilian (2001). Faced with a
problem similar to ours, Bluedorn and Bowdler (2011) nd that the
price responses depend crucially on the number of lags of the monetary
policy shock included in the model: by increasing the number of
monthly policy shock lags from 6 to 48, the price puzzle disappears
while preserving many of the other impulse responses.
It is generally accepted in the literature that monetary policy takes
more than one year to be transmitted fully into the economy and
empirical studies in this area usually consider between 1 to even
4 years lag in their models. Romer and Romer (2004), for example,
include three years lag in their VAR and four years lag in their single
equation model when estimating the response of price to monetary
policy shock.
Lag order selection for a VAR is a sensitive issue with serious consequences. Abadir et al. (1999) show that adding irrelevant variables
(lags) to a nonstationary VAR increases the bias of all the estimators
(this is in contrast with the theory for stationary data where adding
irrelevant variables (lags) increases the variance of estimators but
does not affect biases). They also show that as the dimension of the
VAR increases the variance and hence the mean squared error of the
estimators increases. Their ndings therefore favor parsimonious
modeling.
Consistent with the results of Abadir et al., it is widely believed that a
more parsimonious lag structure in a VAR leads to a better forecasting
performance. For example, Ltkepohl (1985, 1991) shows that the

VARs with the lag orders selected by the SIC perform better in shortrun forecasting. It is well known that the SIC generally underestimates
the lag order of a VAR in small samples and therefore selects a more
parsimonious model.
However, when it comes to impulse response functions the story
changes dramatically. Using a Monte Carlo experiment, Kilian (2001)
shows that the effects of overtting and undertting a VAR are strongly
asymmetric for impulse response functions and the costs associated
with undertting tend to be disproportionately larger. Kilian suggests
that it is safer to include extra lags (even higher lag orders than
suggested by the AIC) rather than to truncate the lag order early. In
summary, it seems that the literature suggests one to select different
lag orders for different purposes: a more parsimonious lag order for
short (to medium) run forecasting whereas a less parsimonious lag
order for impulse response analysis.
Concerned with the extra cost of undertting, we set the maximum
lag at 8, and we increase the number of lags in our model between p = 2
to p = 8. The results show that increasing the number of lags alleviates
the price puzzle, indeed.
Fig. 3 presents the IRFs derived from the VECX* model with p = 8.11
After a contractionary US monetary policy shock, US output falls very
quickly and shows the well-known U-shaped response; the monetary
shock reaches its maximum impact on output after 2 years; the US
ination rises rst and then falls; however, it rises signicantly only in
the rst quarter after the shock and then starts to decline; it becomes
negative after ve quarters and the negative impact on the US ination
becomes marginally signicant after about two years (between the 8th
and 15th quarters); nally the US ination converges to the initial
equilibrium; the US short-term interest rate jumps immediately after
the shock and peaks in the rst quarter and then gradually falls; and
the US long-term interest rate jumps instantly after the shock, peaks
after one year and then steadily declines.
The IRFs of the Canadian variables are similar to the IRFs of the US
variables. Actually, the responses of the Canadian short and long term
interest rates are almost identical to the responses of the US interest
rates. The response of the Canadian ination is slightly weaker and
slower than that of the US ination and the negative response never
becomes signicant. But the negative effect of a contractionary US
monetary shock on the Canadian output is more persistent than on
the US output.12 The responses of the Canadian variables apparently
conrm the interest rate-path-through mechanism as opposed to the
MFD mechanism.

5.2. Impulse Response Function using Romer and Romer (2004) Shock
In order to assess the reliability of the IRFs simulated using the VECX*
model, we also estimate another set of IRFs using Romer and Romer's
(2004) monetary policy shock series. Romer and Romer (2004) employ
a narrative approach to construct a series of US monetary policy shocks
for the period 19691996. They estimate a reaction function in which
the desired Fed Funds target rate, as agreed to at Federal Open Market
Committee (FOMC) meetings, is the dependent variable and the
estimates/forecasts for unemployment, real GDP growth and the change
in the GDP deator, taken from the Greenbook forecasts, are the
explanatory variables.13 The error term from this reaction function is
interpreted as the monetary policy shock. Following Romer and Romer

11

The results for the models with the other lag orders are available upon request.
We also examined whether the IRFs obtained from the VECX* model is sensitive to the
value of * and in Eq. (9). The results show that the variation of * and , where
* {1, 2.0}, {1, 2.2}, has almost no effect on the IRFs in the rst year after the shock
and a marginal effect after the rst year.
13
The Greenbook forecasts are prepared by the Federal Reserve staff and are presented
to the FOMC before each meeting.
12

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

(2004), we estimate the effects of the US monetary shock on US and

Canadian variables using a single equation framework14:

xt a0

I
X
i1

bi xti

J
X

c j st j et ;

j1

where x is the macro variable of interest and st is the Romer & Romer
shock measure. Our regression runs from 1970:01 to 2004:06.15 The
decision to exclude any other explanatory variable from the regression
is based on the assumption that the shock is not affected by other
explanatory variables that inuence the dependent variable. In other
words, the shock is purely exogenous with respect to other variables
by construction. Based on this assumption, the estimates of the coefcients of the regression equation will be unbiased. The dependent
variables, x, are monthly US and Canadian industrial production (IP),
consumer price ination (CPI), treasury bill rate and 10-years government bond rate. Following Romer and Romer (2004), the number of lags
of dependent variable, I, is set at 24, and the number of lags of the shock,
J, is set at 36 (48) for IP (CPI). We set a shorter lag structure for interest
rates, where I = 12 and J = 24, because nancial variables are believed
to respond to shocks more quickly. However, the shape of the responses
of the interest rates to the US monetary shock remain virtually the same
when different combinations of the lag structures (I,J) are considered.
Following Romer and Romer, we assume that the monetary shock
does not affect IP and CPI within the month. However, we allow the
shock to impact interest rates contemporaneously. These assumptions
are consistent with the recursive structure of Christiano et al. (1996,
1999).
The responses of the level of the variables to a Romer & Romer shock
of one percentage point are reported in Fig. 4. The impulse response
functions estimated using the Romer & Romer shock are similar to the
IRFs obtained using the VECX* model with eight lags (Section 1). After
a contractionary US monetary policy shock, US output falls very quickly
(after a small rise at the beginning) and show the well-known U-shaped
response; the monetary shock reaches its maximum impact on output
after two years; the US ination rises rst and then starts to decline;
ination falls below zero after about two years and remains negative
for the rest of the horizon (the high variation of the ination's impulse
response is due to the high volatility of monthly ination); one
difference between these IRFs and the IRFs obtained from the VECX*
model is that the responses of the US and Canadian ination rates
remain signicantly negative after almost four years using the Romer
& Romer shock, whereas they converge to zero in the VECX* model.
This is consistent with the Romer and Romer's (2004) claim that the
response of price to the Romer & Romer shock is stronger than the
response to the shocks derived from the standard recursive identication schemes. The US short-term interest rate jumps immediately

23

after a contractionary US monetary shock and peaks in the rst month

after the shock and then declines gradually; the US long-term interest
rate jumps instantly after the shock, peaks after thirteen months and
then steadily declines; and both the short- and long-term interest
rates converge to their equilibrium, which is around zero, after two
years.
Here again the impulse responses of the Canadian variables
are similar to the impulse responses of the analogous US variables.
The responses of the Canadian short- and long-term interest rates
are almost identical to the responses of the US interest rates.
Similar to the result obtained from the VECX* model, the negative response of the Canadian output is more persistent than that of the US
output.
6. Conclusion
In this paper, following the GVAR modeling strategy we constructed
a two-country VECX* model comprising a structural cointegrated
VARX* for Canada and a structural cointegrated VAR for the US.
We used the VECX* model to shed light on the links connecting the
Canadian economy to the US economy in both short and long run.
The results show that in the long run, the (modied) Fisher equation
and the Term Structure relation hold in both the US and Canadian
economies and the Interest Rate Parity between the US and Canada
is highly crucial in driving the Canadian economy. However, no
strong evidence was found to support the Purchasing Power Parity
and Output Convergence relationship between the US and Canadian
economies.
Then we examined the transmission of US monetary policy shocks
into the Canadian economy using the VECX* model. We found that the
impulse response functions are sensitive to the lag structure. In particular, with a short lag structure (p = 2), the price puzzle was pronounced
and, that increasing the lag order could alleviate the price puzzle. The
impulse responses obtained from the VECX* model with a relatively
large lag order (p = 8) showed that the responses of the Canadian
macro variables to the US monetary policy shock are similar to the
responses of the US macro variables to the same shock: after a contractionary US monetary policy shock, output falls quickly and shows a
U-shaped response, ination falls with a delay and nally converges
to the initial equilibrium, short-term interest rate jumps and then
gradually declines and long-term interest rate increases for one year
and then gradually declines. The impulse responses estimated through
a single-equation model using the Romer and Romer (2004) shock
measure were similar to the impulse responses obtained using the
VECX* model. Our results conrmed that interest rate-path-through is
the most important mechanism by which US monetary policy shocks
are transmitted into the Canadian economy.
Appendix A
A.1. Denitions and sources of variables

14
Romer and Romer (2004) use the single equation regression method to estimate the
effects of the Romer & Romer shock on the US economy. Scrimgeour (2010) uses the same
method to estimate the effects of the Romer & Romer shock on four countries in the
Americas. Our exercise in this section deviates from these studies in several respects,
though in essense is similar to them. First, we use an extended series of the Romer &
Romer shock (our series end in 2004:06 instead of 1996:12). Second, we estimate the response of consumer price ination, and not price level, to the shock (Romer and Romer estimate the effects on the level of PPI for nished goods and Scrimgour does not estimate
the effects of the shock on price level). Third, we estimate the responses of both short
and long term interest rates to the shock where I = 12 and J = 24 (Romer and Romer
do not estimate the effect of the shock on interest rates and Scrimgour esimates only
the response of the short-term interest rate, where he considers I = 24 and J = 36).
15
See Barakchian and Crowe (2013) on how the Romer & Romer shock is extended from
1997:01 to 2004:06. Similar to Romer and Romer (2004), the regression is run from
1970:01 with the values of st before 1969:03 are set at zero.

The data set contains quarterly observations on the US and Canada,

from 1958Q1 to 2004Q2. The Canadian variables included are (log)
real per capita output, yt, (log) price level, pt, the nominal quarterly
short term interest rate, rst , the nominal quarterly long term interest
rate, rlt, and (log) exchange rate, et. Specically
;
p lnP t ;  et lnEt 
yt lnGDP t =POP t ;



s
 t l
s
l
rt 0:25ln 1 Rt =100 ;
rt 0:25ln 1 Rt =100 ;
where GDPt is real gross domestic product volume index (seasonally
adjusted and indexed at 100 in 2000), Pt is the consumer price index
(seasonally adjusted and indexed at 100 in 2000), Rst is the treasury
bill rate (percent per annum), Rlt is the 10 years bond rate (percent

24

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

per annum), and Et is the Canadian currency per US dollar (indexed at

100 in 2000). The US variables, yt , pt , rst , rlt , are constructed using
the same method.
POPt is constructed as a quarterly series through linear interpolation
of the annual series and then converted into an index number (indexed
at 1 in 2000). The oil price variable, pot , is constructed as pot = ln(POILt),
where POILt is the average price of crude oil in terms of US dollar per
barrel (indexed at 100 in 2000).
The data were obtained from the International Financial Statistics,
IMF. GDP and CPI series are seasonally adjusted using the X12-ARIMA
method.
The monthly series used for the single-equation regression model
are the original monthly series (seasonally adjusted series for Industrial
Production and CPI) which were also obtained from the International
Financial Statistics.

0 1

ut

p
X

zt

14

0m
m
Im

to obtain
1

zt

p
X

P0 H

i zti P0 H

a P0 H

bt t

i1

zt CLa bt Hvt

where

t

11


t
;
ut

where

covt

C j L j C1 1LC L;





cov
t ; t  cov t ; ut


covut ; ut
cov ut ; t

with

j0

bt vt :

0 1

P
0mm

P0 H

The moving average representation of the above equation can be

written as

C L

aH

To derive the structural shocks, we premultiply Eq. (14) by

i1

CL

i zti H

i1

i zti a bt Hvt :

0 1

and the identication conditions are given by (i) covt Im
, (ii) P
is lower triangular.
Now, consider the VAR representation of the VECX* model (Eq. (3))
and premultiply it by H1,

P0

In order to derive the formula for impulse response function, we

start with the VAR representation of the VECX* model, Eq. (3):
p
X

t P

"

A.2. Derivation of impulse response function

zt

where P* is the Cholesky

factor of u
; it is an upper triangular matrix
0
such that u
P
P
, and u
covu
t . The structural shocks are
dened as

C j L j;

and C j

j0

 0









1

cov t ; t Im
; cov t ; ut cov P
ut ; ut

0 1

Ci ;

u
;u ; covut ; ut u :

i j1

C0 = Im, C1 = 1 Im, Ci = 1Ci 1 + 2Ci 2 + + pCi p, for i N 2,

and Ci = 0 for i b 0. By forward cumulating of Eq. (11), one can obtain
the moving average representation of the level of variables as

Since vt = P0t, Eq. (12) can be written as

t
X


Hv j C LHP0 t 0 :
zt z0 b0 t C1
j1

t
X


Hv j C LHvt v0 ;
zt z0 b0 t C1

12

Therefore the impulse response function is given by

j1

where b0 = C(1)a + C*(1)b.

To derive the impulse response function of zt + n with respect to a
structural shock, it, requires imposing a structure on the contemporaneous coefcients matrix. As we argued in Section 5, under our assumptions US monetary policy shock is identied by imposing a structure on
the contemporaneous coefcients matrix of the US cointegrated VAR
model while the Canadian model is left unrestricted. So we order the
variables in the US model according to the Christiano et al.'s (1996,
1999) identication scheme as: output, ination oil price, short term
interest rate and long term interest rate.
Consider the US VAR model

xt

p
X

i xti a b t ut :

13

i1

0 1

Premultiply Eq. (13) by P

P

0 1

xt

0 1

i xti P

0 1

a P

0 1

b tP

0 1

ut

1 e


HP S ; i 1; ; m ; n 0; 1;
sir f n; z : i p C
ii n 0 i

A.3. The bootstrap algorithm

To produce critical values for the over-identifying restrictions LR test
using the standard bootstrap, we follow the procedure proposed in
Garratt et al. (2006, Ch. 6). For the wild bootstrap, we follow the same
procedure but instead of resampling the residuals we use the device
suggested by Cavaliere et al. (2010) to generate the wild bootstrap
residuals:
^t n;t
^ t n v
v

15

where {n,t}Tt = 1, n = 1, , N denotes a doubly independent N(0,1)

scalar sequence (T is the sample size and N is the number of iterations
of the bootstrap procedure). Cavaliere et al. show that the simulated
errors preserve the pattern of heteroskedasticity present in the original
sample.

S. Mahdi Barakchian / Economic Modelling 46 (2015) 1126

The algorithm used to produce condence bounds for the persistence proles and impulse response functions is as follows:
Step 1: We follow Cavaliere et al. (2010) and generate the bootstrap
^ t n ; t 1; ; T , according to the device presented
residuals, v
in Eq. (15).
Step 2: Similar to the standard bootstrap procedure, as in e.g. Li and
Maddala (1996), we construct the bootstrap sample z(n)
t , t =
1, , T, recursively using the VAR representation of the VECX*
model
n

zt

^ H
^ zn
^ zn a
^v
^ bt
^ tn ; t 1; ; T;

1 t1
2 t2

16

^ ;
^ ;a
^ ^
where
1
2 ; b and are the estimates of the parameters
of the model obtained from the estimation over 1958Q1
2004Q2, and the actual realizations are used for the initial
values, z1, , zp.
Step 3: Using the simulated sample z(n)
t , t = 1, , T, a structural
cointegrated VARX* for Canada and a structural cointegrated
VAR for the US are estimated for given long run relations. The
short run parameters are re-estimated at each iteration of the
bootstrap procedure. After that, we combine the Canadian
and US models to create a new VECX* model and generate
persistence proles and impulse response functions from the
bootstrapped VECX* model.
Step 4: We iterate Steps 1 to 3, N times to generate N samples of the
persistence proles and impulse response functions.
A.4. Unit root tests

Table 7
Augmented DickeyFuller unit root test for the rst differences of the variables.

ert
rst
rlt
pt
2pt
yt
rst
rlt
pt
2pt
yt
pO
t

ADF(0)

ADF(1)

ADF(2)

ADF(3)

ADF(4)

12.42
10.50
11.60
4.15
19.20
10.51
10.80
10.36
3.79
17.36
9.62
10.09

8.52
9.60*
9.58
3.00
13.66
7.30
10.97
8.78
3.05
14.24
6.87*
9.37

6.06
7.23
6.94
2.47
9.65
5.39
6.42
6.39
2.34
8.21*
6.21
6.71

5.30
7.17
5.87
2.49
10.05
6.02*
6.33
6.28
2.87*
7.63
6.46
667

5.77*
6.04
6.53*
1.93*
9.11*
5.55
4.59*
6.77*
2.67
7.00
5.88
6.75*

Table 8
Augmented DickeyFuller unit root test for the levels of the variables.

ert
rst
rlt
pt
yt
rst
rlt
pt
yt
pot

ADF(0)

ADF(1)

ADF(2)

ADF(3)

ADF(4)

1.83
1.72
1.43
1.13
1.38
1.66
1.45
0.44
2.17
1.37

1.99
2.26
1.62*
0.63
1.61
2.19
1.81
1.12
2.68
1.85

2.14
1.96*
1.51
1.06
1.77
1.63
1.72
1.46
2.99*
1.58

2.58*
2.14
1.65
1.40

2.73
1.89
1.72
1.35
1.73*
2.10
1.79
1.51*
2.63
1.63

2.02
2.31*
1.94*
1.99
2.98
1.82*

Notes: For the rst differences, ADF regressions include an intercept and p lagged rst
differences of dependent variable. But for the levels, ADF regressions include an intercept,
a linear time trend and p lagged rst differences of dependent variable, except for rst, rlt, rst
and rlt which only include intercept. The relevant 5% critical values are 2.88 for the case
with just intercept and 3.45 for the case with both intercept and trend. Symbol * refers
to the order of augmentation chosen by the AIC with a maximum lag order of four. The
sample period is 1958Q1 to 2004Q2.

25

Table 9
PhilipsPerron unit root test for the rst differences of the variables.

ert
rst
rlt
pt
2pt
yt
rst
rtl
pt
2pt
yt
pot

PP(0)

PP(5)

PP(10)

PP(15)

PP(20)

9.28
7.64
6.17
3.84
15.30
8.32
8.11
7.08
2.67
12.24
8.53
4.93

9.74
11.27
14.96
3.58
24.46
6.61
8.46
10.88
2.66
19.24
8.24
6.90

11.14
11.62
15.54
3.37
29.17
6.7
8.37
12.20
2.74
20.58
9.04
6.98

13.22
13.00
17.32
3.28
30.80
5.84
8.73
13.39
2.98
21.09
9.28
7.14

14.69
14.35
18.55
3.21
31.95
5.74
8.88
13.59
3.28
20.66
10.32
7.53

Table 10
PhilipsPerron unit root test for the levels of the variables.

ert
rst
rlt
pt
yt
rs
rlt
pt
yt
pot

PP(0)

PP(5)

PP(10)

PP(15)

PP(20)

1.66
1.06
0.88
1.31
1.43
0.99
0.99
0.49
2.17
1.59

1.49
1.16
0.90
0.66
0.26
1.26
0.88
0.24
1.73
1.26

1.47
1.35
1.08
0.55
1.29
1.37
1.09
0.20
2.05
1.25

1.55
1.50
1.12
0.51
1.38
1.46
1.07
0.19
2.43
1.23

1.70
1.67
1.21
0.51
1.45
1.59
1.11
0.19
2.69
1.22

Notes: PP() represents PhillipsPerron test with Bartlett window of size . For the rst
differences, underlying DF regressions include an intercept but for the levels, DF regressions include an intercept and a linear time trend, except for rst , rlt, rst and rlt which
only include intercept. The relevant 5% critical values are 2.88 for the case with just
intercept and 3.45 for the case with both intercept and trend. The sample period is
1958Q1 to 2004Q2.

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