Time-varying equilibrium rates in small open economies: Evidence for Canada

• We present an unobserved components model designed for small open economies.
• Macroeconomic aggregates are decomposed into equilibrium and transitory components.
• The transitory components are linked to each other within a simple structural model.
• The model is applied to Canadian output, inflation, interest and exchange rate data.

This paper estimates equilibrium rates of macroeconomic aggregates for small open economies. We simultaneously identify the transitory and permanent components of output, inflation, the interest rate and the exchange rate by means of a multivariate trend-cycle decomposition. Realizations of the observed macroeconomic aggregates are explained in terms of unobserved equilibrium rates and unobserved transitory components. The transitory components of the variables are linked to each other through an aggregate demand equation, a Phillips curve, and an equation specifying the interest rate-exchange rate nexus. The model is then applied to Canadian data.