Canada's Experience with a Flexible Exchange Rate in the 1950s: Valuable Lessons Learned

Schembri studies Canada's post-World War II experience in introducing a floating exchange rate, including its effects on the Canadian economy and its influence on the development of macroeconomic theory. In particular, Canada's flexible exchange rate and high degree of capital mobility with the United States provided an unprecedented experiment for macroeconomic policy. The successes and difficulties encountered by Canadian authorities in managing monetary and fiscal policy under this regime drew the interest of researchers at the International Monetary Fund and elsewhere and had a significant impact on the development of the Mundell-Fleming model, the path-breaking innovation in modern open-economy macroeconomics.

Conference Summary: Canada in the Global Economy

The Bank of Canada's 2004 research conference examined the real and financial linkages between the Canadian economy and the economies in the rest of the world. Although Canada has profited enormously from its openness to international trade in goods, services, and financial assets, many of the most significant shocks to the Canadian economy in recent years have come from abroad. For these reasons, understanding the extent and nature of the external linkages, their implications for the Canadian economy, and the process by which the Canadian economy adjusts to external shocks is of critical importance both for monetary policy and for monitoring the financial system. This article describes the purpose of the conference�to deepen economists' understanding of these important issues�and provides highlights of the papers presented in each of the five sessions, as well as summaries of the keynote lecture and the discussion of the policy panel.

The International Monetary System: An Assessment and Avenue for Reform

The current international monetary system is in need of reform. This article first provides an assessment of the existing system, highlighting both its strengths and weaknesses. It notes that the system has not facilitated the symmetric and timely adjustment in the real exchange rate necessary to accommodate the integration of China and other emerging-market economies into the global economy. This lack of adjustment contributed to the global financial crisis and recession and, because it is forestalling the required rotation of global demand, is hindering the global recovery. The article then discusses reform of the system that would see all systemically important countries and currency areas adopt market-based and convertible floating exchange rates supported by appropriate monetary, fiscal and financial sector policy frameworks. It also examines the roles of the G-20 countries and major international financial institutions in promoting and facilitating the system’s transition.

Purchasing-Power Parity: Definition, Measurement, and Interpretation

This article examines the concept of purchasing-power parity (PPP) and its implications for the equilibrium value of the Canadian exchange rate. PPP has two main applications, as a theory of exchange rate determination and as a means to compare living standards across countries. Concerning exchange rate determination, PPP is mainly useful as a reminder that monetary policy has no long-run impact on the real exchange rate, since the exchange rate can deviate persistently from its PPP value in response to real shocks. To compare living standards across countries, PPP exchange rates constructed by comparing the prices of national consumption baskets are used to translate per capita national incomes into a common currency. These rates are useful because they offset differences in national price levels to obtain comparable measures of purchasing power, but they are not an accurate measure of the equilibrium value of the exchange rate. The authors conclude that the current deviation of the Canadian exchange rate from the PPP rate does not imply that the exchange rate is undervalued, but that this deviation reflects the impact of persistent real factors, in particular, lower commodity prices.

The Exchange Rate, Productivity, and the Standard of Living

This article examines the recent proposition that the decline in Canada's standard of living relative to that of the United States is causally related to the decline in our exchange rate. The authors explore the main channels through which the exchange rate and the standard of living could be related-productivity and the terms of trade-focusing mainly on productivity. They conclude that the decline in world commodity prices and weak demand for domestic output were affecting both Canada's standard of living and the exchange rate and that the flexible exchange rate regime itself did not play an independent role.

External Stability, Real Exchange Rate Adjustment and the Exchange Rate Regime in Emerging-Market Economies

In emerging-market economies, real exchange rate adjustment is critical for maintaining a sustainable current account position and thereby for helping to reduce macroeconomic and financial instability. The authors examine empirically two related hypotheses: (i) that real exchange rate flexibility and adjustment promotes external stability, and (ii) that a flexible nominal exchange rate facilitates real exchange rate adjustment. Based on an event-study analysis for a large set of emerging-market economies over the period 1975–2008, the authors find that real exchange rate adjustment has contributed significantly to reducing current account imbalances. The adjustment of current account deficits in countries with a fixed exchange rate regime does not typically occur through the classical adjustment mechanism, but as a consequence of exchange rate crises, where the nominal exchange rate collapses and there are substantial costs in terms of forgone output. Vector-error-correction results support the findings of the event study; namely, in the long run the real exchange rate movements facilitate current account adjustment.Development economics; Exchange rate regimes; International topics

Borders, Common Currencies, Trade, and Welfare: What Can We Learn from the Evidence?

Recent evidence indicates that the intensity of economic exchange within and across borders is significantly different: linkages are much tighter within, than among, nation-states. These findings, however, do not necessarily imply that borders and separate national currencies represent significant barriers to trade that should be removed, since the evidence is also consistent with the alternative hypothesis, that domestic exchange is more efficient because domestic producers are better able to satisfy the requirements of local consumers, owing to common tastes and institutions and the existence of local information and social networks. Focusing primarily on trade linkages within and between Canada and the United States, the authors review the evidence on the extent to which national borders lessen the intensity of international economic linkages, primarily trade in goods and services, and the effects on domestic welfare. They also examine the evidence on the impact of common currencies on trade and welfare. They determine that, since the empirical models employed to date in this research cannot distinguish between alternative explanations of the evidence, it is not yet possible to draw firm conclusions for policy-making.

Canada's Pioneering Experience with a Flexible Exchange Rate in the 1950s: (Hard) Lessons Learned for Monetary Policy in a Small Open Economy

This paper revisits Canada's pioneering experience with floating exchange rate over the period 1950–1962. It examines whether the floating rate was the best option for Canada in the 1950s by developing and estimating a New Keynesian small open economy model of the Canadian economy. The model is then used to conduct a counterfactual analysis of the impact of different monetary policies and exchange rate regimes. The main finding indicates that the flexible exchange rate helped reduce the volatility of key macroeconomic variables. The Canadian monetary authorities, however, clearly did not understand all of the implications of conducting monetary policy under a flexible exchange rate and a high degree of capital mobility. The paper confirms that monetary policy was more volatile in the post-1957 period and Canada's macroeconomic performance suffered as a result.Exchange rates; Economic models

Canada's Pioneering Experience with a Flexible Exchange Rate in the 1950s:(Hard) Lessons Learned for Monetary Policy in a Small Open Economy

This paper revisits Canada's pioneering experience with floating exchange rate over the period 1950-1962. It examines whether the floating rate was the best option for Canada in the 1950s by developing and estimating a New Keynesian small open economy model of the Canadian economy. The model is then used to conduct a counterfactual analysis of the impact of different monetary policies and exchange rate regimes. The main finding indicates that the flexible exchange rate helped reduce the volatility of key macro-economic variables. The Canadian monetary authorities, however, clearly did not understand all of the implications of conducting monetary policy under a flexible exchange rate and a high degree of capital mobility. The paper confirms that monetary policy was more volatile in the post-1957 period and Canada's macroeconomic performance suffered as a result.