Covid-19 and monetary–fiscal policy interactions in Canada

• Estimate policy rules that switch stochastically between regimes. • Use a structural VAR to analyze the effects of fiscal policies at times of crisis. • The positive effects of deficit spending die out with the end of the fiscal stimulus. • Deficit spending leads to higher inflation , creating problems for the central bank. We investigate fiscal–monetary policy interactions in Canada over a period that includes the global financial and Covid-19 crises. We relax the assumption that policy regimes are fixed, and estimate interest rate rules for monetary policy and tax rules for fiscal policy that switch stochastically between two regimes. We also use of a structural vector autoregressive (VAR) model to analyze the effects of fiscal policies, similar to the ones undertaken by the Canadian government (and other governments around the world) during the coronavirus pandemic. We find that fiscal policy has been more active than monetary policy and that deficit spending helps to boost economic activity in the short-run. However, the positive effects on real GDP and real private consumption die out with the end of the fiscal stimulus. Long-term interest rates rise, investment falls, and inflation rises, creating problems for an inflation targeting central bank.

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