Do demographics affect monetary policy transmission in Canada?

• Author: Steve Ambler,Jeremy Kronick
• DOI: http://doi.org/10.1002/ijfe.1691
• Published date: 01 April 2019
• Date: 01 April 2019

Received: 29 March 2018 Revised: 3 August 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1691

RESEARCH ARTICLE

Do demographics affect monetary policy transmission in

Canada?

Jeremy Kronick1Steve Ambler2

1C.D. Howe Institute, Toronto,ON,

Canada

2ESG UQAM, C.D. Howe Institute,

Toronto,ON, Canada

Correspondence

Steve Ambler, ESG UQAM,C.D. Howe

Institute, Toronto,ON, Canada.

Email: ambler.steven@uqam.ca

JEL Classification: E52; E58

Handling Editor: Taylor Mark

Abstract

Using a panel of macroeconomic data for Canada and its 10 provinces, we

estimate the dynamic effects of monetary policy shocks from the mid-1980s

until the present. We then relate the change in the impact of these shocks to

macroeconomic factors including demographics, specifically changes in the old

age dependency ratio. We find that the inflation-targeting regime has had an

ambiguous effect on the impact of monetary policy shocks in Canada. On the

other hand, changing demographics have unambiguously reduced the impact of

monetary policy shocks. This can help to explain tepid inflation since the finan-

cial crisis and could eventually undermine the effectiveness of Canada's inflation

targeting regime.

KEYWORDS

Canada, credit channel, demographic change, inflation targeting, monetary policy

1INTRODUCTION

A large number of countries have adopted inflation tar-

geting (IT) since the early 1990s. Overall, the experiment

with IT has been very successful,1at least until the onset of

the financial crisis and the Great Recession in 2007–2008.

However,since the crisis, inflation has been systematically

below target in many countries in spite of rock-bottom

interest rates and different forms of unconventional mon-

etary policy such as quantitative easing. Canada has not

been spared this phenomenon. Since 2010, inflation in

Canada has averaged 1.6%, well under the 2% target. This

paper asks what role demographic changes, in particu-

lar an aging population, have had on the transmission of

monetary policy. Although demographics is an issue for

both IT and non-IT regimes, we focus on the former as a

result of the missing inflation post-crisis that has plagued

countries whose central banks have an explicit inflation

mandate.2Nevertheless, any country with a central bank

that uses a short-term interest rate as its primary mone-

tary policy instrument would also face the same effects of

demographic change on monetary policy transmission.

The economic context of IT and the transmission of

monetary policy has changed gradually over the last

30 years. Most notably,real and nominal interest rates have

decreased gradually (with a sudden decrease at the onset of

the financial crisis and the Great Recession), and long-run

neutral interest rates are now lower than they were. This

has important consequences for central banks, because

the probability that policy rates will be pushed by nega-

tive shocks to their effective lower bound has increased.

This leaves less room for reducing policy rates in order to

stimulate demand.3

One of the main influences on long-term real inter-

est rates is demographic change. Population growth has

been slowing in developed economies, putting a brake on

the rate of increase of the size of active populations, and

increasing the proportion of older people. As the propor-

tion of older people increases, the long-term equilibrium

real interest rate falls as demand for capital decreases.4

Furthermore, changing demographics in principle can

affect the impact of monetary policy because changes in

interest rateshave different effects on different age cohorts:

this means that the population age pyramid matters for the

Int J Fin Econ. 2019;24:787–811. wileyonlinelibrary.com/journal/ijfe ©2018 John Wiley & Sons, Ltd. 787

788 KRONICK AND AMBLER

response to changes in central banks' policy rates. In turn,

this occurs mainly because individuals' and households'

wealth over the life cycle is not constant.

In Canada, the median age in 1971 was 26.2, and has

steadily risen,5reaching 40.6 in 2017. Additionally, for

the first time, there are now more Canadians over 65

than under 15 (Robson, 2017). Offsetting some of this

increase in median age is the fact that life expectancy has

increased,which hasled some todelayretirement.6Rega rd-

less, Canada's aging population, and the resulting fall in

demand for capital, has pushed down the neutral rate of

interest over the past 10 years and now sits, according to

the Bank of Canada, somewhere between 2.5% and 3.5%.

Additionally, the relationship between the level of eco-

nomic activity and inflation has weakened gradually over

the last 30 years. This has often been referred to as a flat-

tening of the Phillips curve and is true in most industri-

alized economies. The implications of this phenomenon

are mixed. On the one hand, if long-run inflation expecta-

tions are tied to the inflation target, imbalances between

demand and supply are less likely to move inflation from

target. On the other hand, it can also mean that central

banks, in order to alter inflation rates, must affect aggre-

gate demand and output even more than before.7What all

this means is that the Bank of Canada is starting from a

lower neutral interest rate with less room to decrease the

overnight rate, in an environmentwhere they may actually

need to stimulate more than before in order to generate any

desired change in prices.

The goal of this paper is to examine the link between

demographics and the impact of Canadian monetary pol-

icy shocks over time. We use a two-stage estimation pro-

cedure similar to that of Imam (2015). In the first stage,

we use a time-varying coefficient Bayesian vector autore-

gression (TVC-BVAR), where we take advantage of a new

data set from Champagne and Sekkel (2017) for a more

appropriate identification of Canadian monetary policy

shocks. Indeed, this new shock series helps to alleviate

the price puzzle that arises from standard structural vec-

tor autoregression (SVAR) set-ups. We use this TVC-BVAR

to estimate the impact of monetary policy shocks over

the 1985:Q2 to 2015:Q4 period. We measure the impact

of monetary policy shocks by both the maximum and the

cumulative increase or decrease in inflation and unem-

ployment in response to a shock of the same size.

In the second stage, we exploit a database of macroeco-

nomic variables for a cross section of Canadian provinces

and use dynamic panel estimation to evaluate the link

between demographics and the impact of Canadian mon-

etary policy. By exploiting these provincial data sets, we

provide a more accurate assessment of the impact of mon-

etary policy in Canada, in comparison with Imam (2015)

who focuses on a cross section of different countries.

Our primary finding is that demographic change has

reduced the impact of monetary policy shocks. Since mon-

etary policy has been expansionary for the bulk of the

period under analysis, the implication is that lower inter-

est rates have not, all other things being equal, led to

as much increased borrowing and demand, and in turn,

the impact on inflation and the real economy has been

weaker than it would have been in the absence of demo-

graphic change.8We find that the interest rate and credit

channels are important transmission mechanisms high-

lighting the fact that an aging population tends to have

lower debt levels—as the need for significant borrowing

decreases—and are therefore less sensitive to movements

in interest rates. Our conclusion is that demographic

change is a plausible partial explanation for why inflation

has been unable to reach higher levels post-crisis, despite

considerable monetary policy stimulus.

The rest of the paper is structured as follows. In the

following section, we review different possible channels

through which monetary policy operates, not all of which

imply the same sign for the relationship between the old

age dependency ratio and its impact. In Section 3, we

summarize our econometric methodology and results. In

Section 4, we do some sensitivity analysis, including dis-

cussing the results with different lag timing. Section 5

concludes.

2DIFFERENT CHANNELS FOR

MONETARY POLICY

TRANSMISSION

In this section, we look at the three primary transmission

channels discussed by Imam (2015): the interest rate chan-

nel, the credit channel, and the wealth channel. One other

potential transmission channel for a small open economy

is the exchange rate channel.9Our choice to not explic-

itly investigate this channel is due to two factors. First, the

effect of the channel is ambiguous. Aging populations tend

to be characterized by a decline in savingsbut also a decline

in investments. Similarly, public savings and investments

fall with aging populations due to declining revenues and

higher expenditures. It is this combination of private and

public savings or investments that define the net effect on

the current account and therefore on the exchange rate.

Because it is not clear ex ante which of the decline in sav-

ings and investment outweighs the other, the effect of the

channel is ambiguous.

The second reason is that the exchange rate itself, as we

show in the next section, is directly accounted for in the

Bank of Canada's reaction function in the development

of the monetary policy shock series. Therefore, the exoge-

nous component of the monetary policy shock, and the