Why Does Canada have a Floating Exchange Rate Regime

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Why Does Canada have a Floating Exchange Rate
Regime?

• Farid Novin
• Senior Representative of the
• Bank of Canada

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• On a Fixed Exchange Rate
• It would mean that, de facto, Canada would adopt
  U.S. monetary policy, despite the reality that
  the structures of our economies are very
  different and, as a consequence, often require
  different types of adjustments in response to
  global developments. We cannot avoid adjustment
  the question is simply how we adjust to global
  economic forces. With a fixed exchange rate, the
  adjustments would have to come through movements
  in overall output and in all wages and prices.
  History has shown that these adjustments are more
  protracted and more difficult than exchange rate
  adjustments.
• -Mark Carney, December 2007
• Opening statement to the House of Commons
  Standing Committee on Finance

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Outline

• What are the forces moving the Canadian Dollar?
• The Arguments for a Fixed Exchange Rate
• The Arguments for a Floating Exchange Rate

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Economic Growth
Cyclical economic growth
Long term trend of economic growth
Slower than normal recovery
L-shaped recovery
W-shaped recovery
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C Movements and Exports to the USA
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Drivers of the CND
Economic Growth
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• The VIX tracks the implied volatility of the SP
  500, it is often referred to as the fear index
• Last year risk spiked sharply, which sent
  investors into less risky US dollar denominated
  assets, leading the CND to drop from 1.00US in
  July to 0.77US in Oct
• As the level of risk has returned to more normal
  levels in the past few months investors have
  diversified into CND, leading the CND to climb
  back towards year-ago levels

VIX Measure of market risk
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Fixed Exchange Rate Regimes

• The vast majority of countries operate on a fixed
  exchange rate system.
• Most tie their currencies to that of another
  trading partner.
• Reasons
• Currency movements (whether up or down) have
  political repercussions because someone will be
  made unhappy.
• An appreciation renders exports less competitive
• A depreciation renders importers less
  competitive. Consumers will complain about higher
  prices.
• The exchange rate can be a symbol of national
  pride.

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The Arguments for a Fixed Exchange Rate Regime

• Optimal Currency Area
• -- originally Mundell (1990), but more recently
  championed by Thomas Courchene
• Canadas economy has become a series of
  north-south cross-border economies
• BC competes with the Pacific northwest
• Alberta with the Texas Gulf
• Central Canada with New York/ Chicago
• Maritimes with Boston and New England

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Ex. Effect of an energy shock

• In the presence of an external shock (ex. rise in
  energy prices)
• each cross-border region is affected in the same
  way,
• but the energy region (Alberta-Texas Gulf)
  changes relative to the other regions.
• With a floating exchange rate
• an energy shock results in an appreciation of the
  Canadian dollar
• every Canadian region becomes less competitive
  vis-à-vis its US counterpart

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C Closely Correlated with the Price of Crude
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Proposed Fixed Rate

• Courchene and Grubel have independently suggested
  that Canada move to a currency board
• Thomas Courchene (Options Politiques Oct. 2007,
  Feb. 2008 The Globe and Mail Oct. 2007
• Herbert Grubel (Financial Post Jan. 2008)
• The currency board would fix the value of the C
  to the US by buying and selling US at that rate

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The Next Step

• The North American Monetary Union (NAMU)
• One central bank for the 2 countries
• The Bank of Canada would issue its currency so as
  to maintain Canadas seigniorage
• Canada would maintain control over financial
  regulation

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Main Advantages of Floating Rates

• Macroeconomic in nature
• Monetary policy independence
• Inflation targeting
• Ability to respond to fluctuations in demand that
  are unique to the Canadian economy
• Buffer against external and internal shocks

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General Equilibrium Conditions
r
Equilibrium Conditions in the Goods and Services
Markets
Equilibrium Condition in the Loanable Funds
Market
r1
GAP
Y
e
e1
Equilibrium Condition in the Production Factors
Markets
?1
Y
Y1
Yp
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General Equilibrium Conditions With Fixed
Exchange Rate
r
Equilibrium Conditions in the Goods and Money
Markets
The Bank of Canadas Exchange Rate Model
rT1
AD1
GAP
Y
AD2
e
e
SAS
Aggregate Demand has shifted to the left in 2009
Result of no rate cuts -Inflation falls below
target -Output falls
?1 2
Equilibrium Condition in the Labour Market
?2 1
New GAP
Y
Yp
Y1
Y2
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General Equilibrium Conditions With Flexible
Exchange Rate
r
Equilibrium Conditions in the Goods and Money
Markets
The Bank of Canadas Exchange Rate Model
rT1
rT2
AD1
GAP
Y
AD2
e1
e2
e
SAS
Aggregate Demand has shifted to the left in 2009
Result of BoC rate cuts -Inflation remains at
target -Output doesnt drop -Exchange rate
depreciates
?1 2
Equilibrium Condition in the Labour Market
Y
Yp
Y1Y2
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Canada Output and Final Domestic Demand (Volume,
year-over-year percent change)
U.S. Output and Final Domestic Demand (Volume,
year-over-year percent change)
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Other Arguments for a Floating Exchange Rate

• The economic structures are different in Canada
  (commodity exporter) and the US (commodity
  importer)
• Regions in Canada are more similar than Canada-US
  regional similarities
• A monetary union would leave Canada with only 1
  seat, the US would have 12
• Sharp adjustments may occur when fixed exchange
  rates unravel (ex. Argentina, South East Asia)
• Rise of oil prices Nations pegged to the US
  (like the Gulf States) saw increased inflation
  rates

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Inflation Control
Canada
USA
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Conclusion

• As Governor Carney said
• Structures of Canadian and US economies are
  different
• Canada is a net exporter of commodities, US is a
  net importer
• With a fixed exchange rate adjustments must come
  through movements in output and inflation
• The current recession would be deeper and last
  longer if Canada had to keep interest rates high
• A fixed exchange rate would mean taking on US
  monetary policy
• Canada would lose its ability to keep inflation
  low and stable