A new approach to estimating equilibrium exchange rates for small open economies: The case of Canada

This paper proposes a new approach to estimating equilibrium exchange rates for small open economies. We set up a simple structural model of output, the rate of inflation and the real exchange rate. These observed variables are explained by unobserved equilibrium rates as well as unobserved transitory components in output and the exchange rate. Using Canadian data over 1974-2008 we jointly estimate the unobserved components and the structural parameters using the Kalman filter and Bayesian technique. We find that Canada’s equilibrium exchange rate evolves smoothly and follows a trend depreciation. The transitory component is found to be very persistent but much more volatile than the equilibrium rate.