2. Why Canada Needs a Flexible Exchange Rate

Principles of Macroeconomics (with Xtra!)

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Bank of Canada Banque du Canada Working Paper 99-12 / Document de travail 99-12 Why Canada Needs a Flexible Exchange Rate by John Murray
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ISSN 1192-5434 ISBN 0-662-27997-2 Printed in Canada on recycled paper
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Bank of Canada Working Paper 99-12 July 1999 Why Canada Needs a Flexible Exchange Rate* by John Murray International Department Bank of Canada Ottawa, Canada K1A 0G9 E-mail: jmurray@bank-banque-canada.ca *Prepared for a conference hosted by Western Washington University 30 April 1999. The views expressed in this paper are those of the author. No responsibility for them should be attributed to the Bank of Canada.
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iii Contents Acknowledgements. ............................................................................................................. iv Abstract / Résumé. ................................................................................................................ v 1. Introduction. .......................................................................................................................... 1 2. Advantages of a flexible exchange rate . ............................................................................... 2 2.1 Some important conditions . ......................................................................................... 2 2.1.1 Different monetary policy objectives and policy-making ability . ...................... 2 2.1.2 Institutional and structural differences. ............................................................... 3 2.1.3 Nominal wage-price stickiness and immobile factors of production. ................. 3 2.1.4 Real wage-price stickiness. ................................................................................. 3 2.1.5 Shortage of policy tools . ..................................................................................... 4 3. Advantages of a fixed exchange rate . ................................................................................... 5 4. All fixed exchange rates are not alike. .................................................................................. 6 5. What system would be best for Canada?. ............................................................................. 7 6. Some potential problems. .................................................................................................... 15 6.1 Concerns that exchange rate movements are dominated by destabilizing speculation. ........................................................................................... 15 6.2 Concerns that flexible exchange rates lead to loose fiscal policy. ............................. 18 6.3 Concerns that flexible exchange rates reduce world trade and investment . .............. 19 6.4 Concerns that flexible exchange rates hurt productivity. ........................................... 19 7. Looking ahead . ................................................................................................................... 21 References .................................................................................................................... 23
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iv Acknowledgements I would like to thank my colleagues at the Bank who provided many useful comments and suggestions on an earlier draft of the paper, in particular, Chuck Freedman, David Laidler, David Longworth, James Powell, Larry Schembri, Pierre St-Amant, and Francine Rioux. I would also like to absolve them of any responsibility for the remaining errors and oversights.
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v Abstract Increased interest has been shown in recent months regarding the feasibility and potential advantages of a common currency for Canada and the United States. This paper explores the argu- ments for and against such an arrangement and attempts to determine whether it would offer any significant advantages for Canada compared with the present flexible exchange rate system. The paper first reviews the theoretical arguments advanced in the economics literature in support of fixed and flexible currency arrangements. A discussion of Canada's past experience with the two exchange rate systems follows, after which there is a survey of the empirical evidence published on Canada's current and prospective suitability for some form of fixed currency arrangement with the United States. The final section of the paper examines critically a number of concerns raised about the behaviour of the current flexible exchange rate system. These concerns include its sus- ceptibility to destabilizing speculation; the depressing effect it might have on trade and investment flows; the encouragement it might provide for lax fiscal policies; and the harmful effect it might have on productivity. On the basis of the evidence reviewed in this paper, the author concludes
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