It always seems to be the right time to debate Canada’s flexible exchange rate. As figure 1 shows, the Canadian-US dollar exchange rate has fluctuated a great deal over the past quarter-century, and there has been no shortage of people who argue that these fluctuations represent a real problem for the Canadian economy. (The exchange rate in figure 1 is the annual average of the Canadian-dollar price of the US dollar, so a rise in the exchange rate is a deprecia- tion of the Canadian dollar.)
In the late 1980s and early 1990s, many Canadians wor- ried about the dollar’s 20 percent appreciation against the US dollar. By 2001, after the onset of the Asian crisis, other Canadians worried about the problems of a weak Canadian dollar, which by then had depreciated to an all-time low. But over the past six years, with the dramatic 60 percent appre- ciation, the arguments from the late 1980s have re-emerged.
During each of these episodes, debate has raged over what should be done about an excessively flexible exchange rate. Some people have argued that Canada needs to fix the value of its currency in order to reduce economic volatility. Often implicit in this argument is the idea that currency ”œmisalignments” are a serious problem, and that a fixed exchange rate is the obvious solution. Arguments have also been heard regarding how the Bank of Canada should respond to exchange rate changes, and simple rules of thumb have been offered ”” such as that the Bank of Canada should reduce its policy interest rate whenever the Canadian dollar appreciates.
Each of these arguments has considerable surface appeal, but each is also wrong. This paper examines three popular myths about Canada’s flexible exchange rate with the goal of clarifying these important issues.
Myth number 1: Economic volatility would be reduced by fixing the exchange rate. At first blush, it seems rather obvious that by fixing the external value of the Canadian dollar we could reduce the amount of economic volatility. After all, for those people engaged in the buying or selling of goods or assets across international boundaries, exchange rate volatili- ty is a problem because it creates risk and uncertainty. And so by fixing the exchange rate we could eliminate an important part of the economic volatility these people face on a daily basis.
The problem with this view is that it misses an important part of the big- ger picture. In particular, it fails to rec- ognize that in an open economy like Canada’s, with billions of dollars worth of goods and services and assets being traded every day, changes in Canada’s exchange rate don’t just hap- pen out of the blue. On the contrary, they are caused by real-world events that would occur no matter what kind of exchange rate ”” fixed or flexible ”” Canada chooses to have.
Consider three broad causes of exchange rate changes. First, changes in world commodity prices, including the prices of energy products, have signifi- cant effects on the Canadian exchange rate for the simple reason that Canada is a large producer and exporter of these products. When the world is willing to pay more for copper or oil or natural gas or newsprint, the heightened demand for these products leads to an apprecia- tion of the Canadian dollar.
Second, changes in the demand for Canadian real and financial assets also lead to changes in the Canadian exchange rate. If global investors per- ceive shares of Canadian firms to be a better investment, or Canadian gov- ernment bonds to be less risky, their greater demand for these assets will lead to an appreciation of the Canadian dollar. Finally, changes in monetary or fiscal policy in Canada can also lead to changes in the exchange rate, mostly through the effect that policy-induced changes in short-term interest rates or income tax rates have on global investors’ demands for Canadian assets.
When any one or more of these economic ”œshocks” occur, the Canadian economy will be forced to adjust. If the Canadian exchange rate is flexible ”” meaning that its value is freely determined by demand and sup- ply conditions in the foreign exchange market ”” some of the adjustment will fall on the exchange rate itself. There will also be some adjustment in Canadian production, income and employment. If the Canadian exchange rate is instead held fixed, the necessary economic adjustment will still occur. But the inability of the exchange rate to move will force more adjustment in the other variables. The result will be more, not less, aggregate economic volatility.
To illustrate this idea, consider two events in recent Canadian economic history: the Asian crisis in 1997-98 and the global commodity boom in 2002- 06. These two events show clearly how Canada’s flexible exchange rate helped to reduce overall economic volatility from what would have been observed if Canada had instead operated under a fixed exchange rate. This is the often- heard idea that flexible exchange rates act as a ”œshock absorber.”
In the summer of 1997, the onset of the Asian crisis led to large declines in the national incomes of Thailand, Indonesia, Malaysia and South Korea. These economies are large users of raw materials, and when their recessions took hold there was a large reduc- tion in the global demand for commodities. Over the next 12 months, world commodi- ty prices fell by roughly 30 percent. As a large producer and exporter of these raw materials, Canada was clearly harmed by this reduction in prices. Particularly hard hit, not surprisingly, were those sectors and regions heavily oriented toward pro- ducing raw materials. The decline in global demand for commodities also led to a decline in demand for the Canadian dollar, which promptly depreciated from US72 cents in 1997 to US65 cents a year later. As a result of this currency depreci- ation, Canadian producers and exporters of manufactured goods, mostly located in central Canada, experienced a significant boost to their business; the cheaper Canadian dollar meant that for- eign purchasers were more likely to buy from Canada than from other countries. In the face of the Asian crisis, the Canadian economy was therefore con- fronted with offsetting pressures. The commodity-producing sectors and regions experienced a decline in econom- ic activity, but the central Canadian man- ufacturing sector, aided by the weaker Canadian dollar, experienced a boom.
Now consider what would have happened if Canada had instead had a fixed exchange rate in 1997. The Asian crisis would still have hap- pened, as would the decline in the global demand for com- modities. As a result, there would still have been the 30 percent decline in the world prices of raw materials, and thus the commodity-producing sectors and regions of Canada would still have faced economic decline. In other words, the negative part of the story for Canada would have been no different had we operated a fixed exchange rate. The difference, of course, would have been that the Canadian dollar would not have been free to depreciate by 10 percent, and thus the central Canadian manufacturing sector would have not received the boost that it actu- ally did.
In terms of aggregate income and employment, Canada’s economy would have been less stable with a fixed exchange rate. The flexible exchange rate that Canada actually had in 1997 helped to stabilize Canadian aggregate income and employment, because it absorbed some of the shock of the Asian crisis.
Now consider the events that took place a few years later. Between 2002 and 2006, a booming world economy led to growing demand for commodi- ties and thus a rapid rise in their prices. The average price of the commodities produced and exported by Canada increased by over 90 percent during this period, and the price of energy products increased even faster than the average. This growing demand for Canadian raw materials naturally led to a boom in Canada’s resource sector, especially notable in the oil-producing regions of the West and Atlantic provinces. The rise in commodity prices was also a key factor in the appreciation of the Canadian dollar, which increased from a low of US62 cents in 2002 to over US90 cents in 2006. But as the Canadian dollar appreciated so dramat- ically, the central Canadian manufac- turers saw their foreign markets shrink and their profit margins fall. Once again the Canadian economy was con- fronted by offsetting pressures, but this time the dynamics were opposite to those following the Asian crisis: the resource sectors and regions experi- enced the boom while the manufactur- ing sector, harmed by the rising dollar, experienced the decline.
If Canada had instead had a fixed exchange rate during this period, the external events would still have happened as they did, but their effect on the Canadian economy would have been quite different. The booming world economy would still have driven commodity prices upward, and the boom in Canada’s resource sector would still have occurred. Without the appreciation of the Canadian dollar, there would have been no force acting to slow down the manufacturing sec- tor. The result would have been an aggregate Canadian economy with even faster growth in aggregate income and employment than we actually experienced during this period. This may sound all to the positive, until it is recognized that even with the appreci- ation that we observed, the Canadian economy was operating roughly 1 per- cent above its productive capacity by early 2007; without the appreciation and the slowdown in the manufactur- ing sector, this ”œoutput gap” would have been even larger, with an associat- ed increase in the already considerable inflationary pressures.
Once again, Canada’s economy would have been less stable with a fixed exchange rate. The flexible exchange rate that Canada actually had in the 2002- 06 period helped to stabilize Canadian aggregate income and employment because it absorbed some of the shock of the global commodity price boom.
This second Canadian example illustrates perfect- ly a problem known to econo- mists as the ”œDutch disease,” the phenomenon first observed after the discovery of natural gas in the Netherlands in the late 1950s. A rise in the price of natu- ral resource products first leads to an appreciation of an exporting country’s currency. And then, because of that currency appreciation, the same coun- try experiences a weakening in its sec- tors exporting other products. Through the appreciation of the cur- rency, the success in the natural resource sector ”œcrowds out” activity in other exporting sectors.
It is surely unpleasant to be either a firm or a worker in one of those sec- tors that are getting ”œcrowded out” fol- lowing a currency appreciation. Firms will reduce output and some may close down altogether. Profits will fall. Workers will receive fewer hours and some will be laid off. None of this is pleasant at the level of the individual worker or firm. But the Dutch Disease ”” which is just a more dramatic name for the shock absorber referred to above ”” is a vital part of the macro- economic adjustment process that helps, through changes in the exchange rate, to stabilize aggregate income and employment.
In the face of positive external shocks like the ones we have been dis- cussing, a fixed exchange rate would help to reduce the impact of the Dutch disease. It is not at all surprising that since 2002 it is the central Canadian manufacturers who have complained the loudest about Canada’s appreciat- ing currency. But reducing the Dutch disease does not mean having a healthier overall economy. The result of fixing the exchange rate would have been an aggregate economy producing well above its productive capacity and inflationary pressures to match.
This is precisely what we observe now in the oil-exporting Gulf States, which peg their currencies to the US dollar. Their fixed exchange rate may have prevented the Dutch disease, but they now have super charged economies with inflation ranging between 4 percent and 12 percent annually.
The bottom line is that the Canadian economy will always be subject to shocks, some from outside and some created internally. When these shocks occur, some adjustment is necessary. But we have a choice regarding the nature of this adjust- ment. We can choose to fix the exchange rate, thus forcing all of the adjustment onto domestic income, employment and inflation. Or we can choose to let the exchange rate absorb some of the shock, thus helping to sta- bilize aggregate income, employment and inflation. For greater stability in the aggregate economy, flexible exchange rates are the better option.
Myth number 2: Canada needs a fixed exchange rate to prevent currency mis- alignments. One often sees in the business press the concept of a currency ”œmisalignment,” where the user of the term argues that the Canadian dollar is either ”œovervalued” or ”œundervalued.” The same person typically argues that by fixing the exchange rate, these misalign- ments can be avoided. Like the first myth, this idea has surface appeal. After all, if such misalignments are known to exist, it seems simple to avoid them by fixing the exchange rate at the appropri- ate level. The problem is that the terms in quotation marks above either are used in a quite imprecise way or are quite pre- cisely grounded in an idea with little or no theoretical or empirical support.
When the value of the Canadian exchange rate is determined through the buying and selling actions of mil- lions of individual traders in the for- eign exchange market, it makes little sense ever to think of the exchange rate as being at the ”œwrong” level. On the contrary, whatever events or expecta- tions are leading the buyers and sellers in that market to make their transac- tions, one can sensibly conclude that the exchange rate is at the ”œright” value every day ”” ”œright” in the sense that the foreign exchange market is equili- brating the forces of demand and sup- ply. This in no way suggests that the ”œright” value of the exchange rate will be constant. As economic events and expectations change on a daily basis, so too will the exchange rate that clears the foreign exchange market.
If the flexible, market-determined Canadian exchange rate is always at its ”œright” value, then what do people mean when they speak of currency ”œmisalignments”?
Sometimes the terms ”œovervalua- tion” and ”œundervaluation” are used in a sloppy but mostly harmless manner. For example, if the Canadian dollar is today trading at US95 cents cents but for some good reason is expected to depreciate to US90 cents cents over the coming months, one might say that the Canadian dollar is ”œovervalued” by 5 cents. This is a sloppy way to use the word because it confuses the question- able idea of a currency ”œmisalignment” with the perfectly sound idea that curren- cies often move more in the short run than they do in the long run. This second idea, usually referred to as exchange rate overshooting, was first made famous in the mid-1970s by the late Rudiger Dornbusch from MIT, who used the idea to explain why exchange rates appeared to be more volatile than their underlying economic determinants.
More often, however, people who speak of ”œover-” or ”œundervalua- tion” actually believe that the current market-determined value of the exchange rate is ”œwrong.” Note how unusual a claim this is; indeed, in any other context it would be viewed as sim- ply silly. Would anyone ever claim that the world price of oil is not ”œright”? They may well claim that the current high price will not last for long, or perhaps that it will soon move even higher. But they wouldn’t say that the current price is ”œwrong” in any meaningful sense. How about the price of orange juice or newsprint or computer RAM chips or fibre optic cable? Do we ever think their market prices are ”œwrong”? The answer is no, and for the very good reason that in each case the market forces of demand and supply are determining their prices. But then why would it ever seem sensible to claim that a market-determined exchange rate is ”œmisaligned”?
People who talk about currency mis- alignments invariably have the the- ory of purchasing power parity (PPP) in their minds. This theory begins with a very sensible idea and then applies it in an entirely inappropriate way. The result is a central prediction which makes little sense and which, not surprisingly, has little or no empirical support.
Economists speak almost with rever- ence of the law of one price, the idea that the difference in prices between one product in New York and the identical product in London cannot exceed the cost required to transport the product between the two cities. If the price differ- ence exceeded the transportation costs, profits could easily be made by buying in the low-price location and selling in the high-price location. But this very act of arbitrage, by adjusting demands and supplies in each location, would then quickly bring the prices back together.
The law of one price is very sensi- ble. The problem comes when the same logic is applied to national price index- es which comprise thousands of prod- ucts. To clarify the issue, let’s introduce some very simple notation. Let e be the nominal Canadian-US exchange rate ”” the number of Canadian dollars required to purchase one US dollar. Further, let PC be the Canadian price index (such as the GDP deflator) and PUS be the similar price index in the United States. The theory of purchasing power parity holds that the exchange rate should equalize the Canadian-dol- lar value of the two price indices:
PC = ePUS
The problem is that this equation does not come close to holding in reality. To see this, we can compare the actual exchange rate, e, to the exchange rate that would be observed if the equation above held. That is, define the PPP exchange rate to be: ePPP ≡ PC/PUS
Now we need only compare the actual path of e with the easily com- puted path of ePPP. If the two paths are similar, then the theory of PPP receives considerable support; if, in contrast, the two paths are quite different, then there is little evidence for the theory.
Figure 2 shows these exchange rates over the past 25 years. The PPP exchange rate is just the ratio of the two national price indices, and because the two countries have similar infla- tion histories this hypothetical exchange rate doesn’t show much variation. In contrast, the actual Canadian- US exchange rate is far more volatile and remains far away from the PPP exchange rate for extended periods of time. This lack of empirical support for PPP is not surprising, however, given that there are very sensible reasons to expect PPP not to hold. As it turns out, the compelling logic of the law of one price disappears when it is applied to national price indexes.
Three main reasons account for the failure of PPP. First, many of the prod- ucts in any national price index are goods or services that cannot be traded inter- nationally. For these prod- ucts, there is no simple international arbitrage that would equate their prices across countries. Second, countries have different con- sumption and production baskets that are used to construct their national price indices, and with differ- ent baskets all that is necessary to break the hypothesized PPP equality is move- ments in relative prices. For example, the prices of forest products may, through arbitrage, be equated between Canada and the United States, but if these prod- ucts are a larger share of Canadian pro- duction than US production (as they are), then any increase in the relative price of forest products will lead to a deviation of the actual exchange rate from the PPP exchange rate. This is pre- cisely why increases in world commod- ity prices lead to an appreciation of the Canadian dollar (even though they have much less effect on the PPP exchange rate).
Finally, note that the arbitrage- based logic of the law of one price applies to the market for goods and services. Yet an important part of the action in the foreign exchange market is played by global investors who are purchasing and selling real and finan- cial assets denominated in various currencies. Changes in the composi- tion of international investment port- folios can easily lead to sustained deviations of the exchange rate from its PPP value.
The bottom line is that the theory of purchasing power parity has serious shortcomings and provides no solid basis for viewing the current exchange rate as ”œmisaligned.” The current value of the exchange rate, determined as it is in the foreign exchange market, repre- sents the ”œright” value in the sense that it is equilibrating demand and supply. As these forces change, so too will the market-determined exchange rate. But there is no need to fix the exchange rate to assure we have its ”œright” value; the foreign exchange market is already accomplishing this task every day.
Myth number 3: The Bank of Canada should reduce interest rates when the dollar appreciates. With the dramatic appreciation of the Canadian dollar over the past six years, from US62 cents in 2002 to roughly par today, many observers have urged the Bank of Canada to respond to the dollar’s appreciation by lowering its target for the overnight interest rate. The logic for this argument is straightforward: the rise in the dollar reduces the foreign demand for Canadian exports of all kinds, and thus will eventually lead to a reduction in economic activity. The Bank of Canada, interested in maintain- ing aggregate output close to capacity as a means of stabilizing inflation, should therefore reduce its policy interest rate. Such an action would stimulate aggre- gate demand and help to offset the slowing effects of the appreciation.
Like the other two myths, this argument is also appealing at first blush. The problem is that the pro- posed simple rule of thumb ”” that currency appreciations should be fol- lowed by interest rate reductions ”” fails to recognize that there must be some underlying cause to the change in the exchange rate, and the specific cause will determine the overall effects on the aggregate economy. Before the Bank of Canada can take any action designed to keep inflation close to its 2 percent target, it is essen- tial that it understand the underlying cause of any significant and sustained change in the exchange rate.
In other words, not all currency appreciations are the same. In what fol- lows, two types of exchange rate changes are examined. In both cases, the Canadian dollar appreciates, but the appropriate action by the Bank of Canada is different. Keep in mind that the objective of the bank is to maintain inflation close to the 2 percent target, and this is accomplished by keeping aggregate output close to its capacity level.
The last several years have present- ed Canada with two distinct types of currency appreciations. Following the language introduced in a February 2005 speech by Governor David Dodge, we can think of type 1 and type 2 shocks. An appreciation caused by a type 1 shock occurs when there is an increase in the global demand for Canadian-produced goods and servic- es. The simplest example is rising world commodity prices, like those observed between 2002 and 2006. An apprecia- tion caused by a type 2 shock occurs when there is either an increase in global demand for existing Canadian assets or a multilateral exchange rate adjustment. The weak- ening of the US dollar against major world curren- cies that has occurred over the past several years is a good example. During the past several years, both type 1 and type 2 shocks have contributed to an appre- ciating Canadian dollar, and a central difficulty for the bank, at any given time, has been to determine the rela- tive importance of each type.
The essential difference between these two types of currency apprecia- tions is that the type 1 shock begins with a direct boost to Canadian aggregate demand for goods and services, whereas the type 2 shock has its initial effect on asset markets. This simple but crucial dif- ference explains why the two shocks have fundamentally different implica- tions for the bank’s monetary policy. Let’s see this in a little more detail.
Consider an economy with aggre- gate output initially equal to its capacity, and then a type 1 shock occurs ”” for example, a rise in world com- modity prices. The rise in the prices of Canadian exports is a direct boost to aggregate demand; Canadian income and employment will rise. This is the direct effect of the shock. But as the Canadian dollar appreciates, and non- commodity exports become more expensive to foreign buyers, some of this aggregate expansion is reversed. (This is precisely the operation of the Dutch disease discussed above.) This is the dampening effect of the shock. But the overall effect is an expansion of Canadian aggregate demand. And if the initial shock is significant and expected to persist, the ultimate effect will be to push aggregate output above its capaci- ty and thus to increase inflationary pressures. To maintain its inflation tar- get, the bank will respond by raising its target for the overnight interest rate.
Now imagine that the same econo- my is instead confronted by a type 2 shock ”” for example, a general weak- ening of the US dollar against all major currencies. There is no direct effect from this shock on Canadian aggregate demand. But as the Canadian dollar appreciates, we get the same dampen- ing in Canadian exports as with the type 1 shock. So there is no direct boost to aggregate demand but there is a dampening due to the appreciation. The overall effect is therefore a reduc- tion in Canadian aggregate demand. If the shock is significant and expected to persist, the ultimate effect will be to push aggregate output below its capac- ity and to reduce inflationary pressures. To maintain its inflation target, the bank will respond by reducing its target for the overnight interest rate.
Some people might argue that the Bank of Canada would be inconsistent if it were to follow the actions described above. In the first case, the appreciation is followed by a tightening of monetary policy, while in the second case the appreciation is followed by a loosening. But there is no inconsistency. In both cases, the Bank of Canada is taking an action designed to keep inflation close to the 2 percent target, and that is accomplished by trying to keep aggre- gate output close to its capacity level.
The Bank of Canada cares a great deal about changes in the Canadian exchange rate, but not because it is tar- geting a specific value. It cares about exchange rate changes for two reasons. First, such changes reveal the underlying economic shocks that are hitting the Canadian economy. Second, the exchange-rate changes themselves, by changing international relative prices, will have an effect on patterns of Canadian production and consumption.
The bottom line is that there are many possible sources of exchange rate changes, and the Bank of Canada’s appropriate response to any given change depends crucially on the cause of that change. The bank does not target any specific value of the exchange rate, but nonetheless pays close attention to exchange rate changes. A flexible exchange rate is a crucial part of the bank’s overall inflation-targeting regime.
