Determinants of the long term interest rate in Canada
Creators: name: Mouat, Robert Lawrence
Publisher: name: University of British Columbia
Year: 2010

description: The purpose of this thesis was to develop a model that would demonstrate whether the government of Canada can effect an independent, or partially independent long-term interest rate policy with respect to the United States. The theoretical analysis of the economics resulted in four distinct equations for long-term interest rate determination; two for each of a closed economy model and an open economy model. The first equation for the closed model relates long-term interest rates to the rate of change of money supply, government expenditure and inflation. The second equation replaces government expenditure with unemployment, all other variables remaining the same. The variables of the two equations for the open economy were identical with those of the closed model. However, the open economy had values of the dependent variable which were the difference between the Canadian and U.S. long-term interest rates and values for the independent variables which were the differences between the Canadian and U.S. values of the rate of change of (for the first equation) money supply, inflation and government spending and (for the second equation) money supply, inflation and unemployment. Quarterly data were used over 92 periods from 1953 to 1975 inclusive with money supply and government spending being corrected for inflation. The long-term interest rate were government bond yields of ten years and over; the money supply were the sum of demand deposits plus currency held outside the banks; the government spending were total federal government expenditures and; the inflation rate were the gross national expenditure deflator. The equations were analysed using a routine which combined the Almon lag technique with the Cochrane-Oreutt method of regression. This allowed a selection of the lag length and the degree of the polynomial of the equation. In all of the equations in this paper the lag length is four periods and the degree of the polynomial is two. For the closed economy model the results showed the expected signs (money supply and unemployment negatively related, and inflation and government spending positively related), with few exceptions, the most notable being a negative government expenditure in the first lag period. The values of the coefficients indicated that inflation was the greatest influence on long-term interest rates, money supply and unemployment having a much smaller influence,and government expenditure having almost no affect over the four lag periods. The open economy model results showed the expected signs for the coefficients with a similar exception to the closed model. The value of the coefficients indicated that the inflation differential of the two countries was the greatest influence on the long-term interest rate differential with the money supply differential second, unemployment differential third and government expenditure differential having almost no explanatory power. Money supply differential had four significant lag coefficients indicating a divergence between monetary policy of Canada and the U.S. (whether intended or not). It appears from the results that although the U.S. largely controls Canada's long-term interest rate, Canada has the ability, whether it is used or not, to control part of its long-term interest rate. The differential of Canada and the U.S's rate of change of inflation, money supply and unemployment all influence the level of long-term interest rates. The control of these variables is the key to the government's control over the long-term interest rate.