Financial Conditions Indices for Canada

In this paper, we construct several FCIs for Canada based on three approaches: an IS-Curve-based model, generalized impulse response functions and factor analysis. Each approach is intended to address one or more criticisms applied to MCIs and existing FCIs. We evaluate our various FCIs based on their weights, dynamic correlation with output and inflation, their in-sample fit in explaining output and their out-of-sample forecast performance. Based on the IS-Curve method with monthly data, we find that housing prices, equity prices and bond yield risk premia, in addition to short- and long-term interest rates and the exchange rate, are significant in explaining output from 1981 to 2000. In both the HP-filter and first difference specifications, housing prices have a higher or comparable absolute-value coefficient than that of the exchange rate. Finally, we find that the FCI outperforms the MCI in many criteria considered in this paper.

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