This paper empirically provides new evidence on the relation between inflation, relative price variability and economic performance or living standards to a panel of Canadian provinces over the period 1981-2010. We use the Bick and Nautz (2008) modified version of Hansen's (1999) Panel Threshold Model. The evidence strongly supports the view that the relationship between inflation and economic growth is nonlinear. Further investigation suggests that relative price variability is one of the important channels through which inflation affects economic performance in Canadian provinces. When we control cross-section dependency and use the appropriate method, we find the critical threshold value slightly changes. Our findings are consistent with the claims of Blanchard et al. (2010) who suggest that an inflation target of 4 percent might be more appropriate because it leaves more room for expansionary monetary policy in the case of adverse shocks. These findings provide some policy implications. It is desirable to keep inflation in the moderate inflation regime and therefore the Bank of Canada should concentrate on those policies which keep the inflation rate between 1.82 percent and 4.16 percent because it may be helpful for the achievement of sustainable economic growth and to improve the living standards of Canadian provinces. The results seem to indicate that inflation that is too high or too low may have detrimental effects on economic growth. This information gives a very important signal for Canadian policymakers to impose new policies to provide economic stabilization through Canadian provinces.

Although the Bank of Canada admits stock market price index are considered in its policy deliberations because of their effects on inflation or output gap, the Bank of Canada denies trying to stabilize asset prices around fundamental values. However, since the start of the Bank of Canada we have seen a boom as well as a bust in the stock market. Are we to believe that the Bank of Canada did not react to these stock market fluctuations, apart from their impact consequences on economy? We investigate this issue by using a structural model based on the New Keynesian framework that is augmented by a stock market variable. We use an econometric method that allows us to distinguish the direct effect of stock prices on Bank of Canada policy rates from indirect effects via inflation or GDP. Our results suggest that stock market stabilization plays a larger role in Bank of Canada interest rate decisions than it is willing to admit. Empirically to infer the monetary policy preferences and having a best interpretation of the parameters, we follow Favero and Rovelli's (2003) approach. The results reveal practical monetary policy lessons: (i) Canadian monetary authorities should generally respond to stock market price index as long as this variable contain reliable information about inflation and output, but it should not respond to asset prices if there is considerable uncertainty about the macroeconomic role of asset prices. This finding holds even if a monetary authority cannot distinguish between fundamental and bubble asset price behavior. (ii) The monetary authorities' preferences have changed between different subperiods. In particular, the parameter associated with the financial indicator's target is highly significant at the last subperiod. Furthermore, these results give new insights into the influence of financial variables on monetary policy and should provide relevant understandings regarding the opportunities and limitations of incorporating financial indicators in monetary policy decision making. This indicates that while the Bank of Canada is targeting the information contained in this index in order to avoid inflationary pressures from imbalances in the asset and financial markets. (iii) The findings suggest that the introduction of inflation targeting in Canada was accompanied by a fundamental change in the objectives of monetary policy, not only with respect to the average target, but also in terms of precautions taken to keep inflation in check in the face of uncertainty about the economy. The economic conditions related to the aggregate demand have been favorable in comparison with those related to the aggregate supply and the stock market price fluctuations. The main contribution of this paper is to successfully not only prove that the Bank of Canada does care about output and stock market price stabilization (in addition to inflation stabilization) but reveal that targeting financial conditions might be the solution to avoid imbalances in the financial and asset markets and, consequently, to av...