5. The Exchange Rate Regime and Canada's Monetary Order

Principles of Macroeconomics (with Xtra!)

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Bank of Canada Banque du Canada Working Paper 99-7/Document de travail 99-7 The Exchange Rate Regime and Canada’s Monetary Order by David Laidler
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ISSN 1192-5434 ISBN 0-662-27770-8 Printed in Canada on recycled paper
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Bank of Canada Working Paper 99-7 March 1999 The Exchange Rate Regime and Canada’s Monetary Order by David Laidler Visiting Economist and Special Adviser Bank of Canada Ottawa, Canada K1A 0G9 [email protected] 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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Contents Acknowledgements ........................................................................................................................ iv Abstract ............................................................................................................................................ v 1. Introduction .................................................................................................................................. 1 2. The role of the exchange rate in the current monetary order ....................................................... 3 3. Criticisms of Canada’s flexible exchange rate ............................................................................. 5 4. North American Monetary Union as a monetary order ............................................................... 9 5. A currency board ........................................................................................................................ 13 6. A legislatively fixed exchange rate ............................................................................................ 15 7. A pegged exchange rate ............................................................................................................. 17 8 Concluding comments ................................................................................................................ 21 References ...................................................................................................................................... 22
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Acknowledgements I am grateful to Pierre Duguay, Chuck Freedman, Paul Jenkins, John Murray, James Powell, Ted Requard, Larry Schembri, and Mark Zelmer for comments on an earlier draft of this paper. I am also grateful to Peter Spiro for helpful discussions of productivity growth questions. iv
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Abstract It is a mistake to debate the merits of alternative exchange rate regimes for Canada independently of other features of the monetary order. A coherent order requires a well-defined goal for monetary policy, one that the authorities are capable of achieving, and that anchors private sector expectations. For it to be liberal, the relevant authorities should be accountable to the electorate for their performance. These criteria are applied in comparing the merits of: (i) Canada’s current monetary order, based on inflation targets and a flexible exchange rate; (ii) a North American monetary union; (iii) a Canadian currency board; (iv) a legislatively fixed exchange rate; and (v) an adjustably pegged exchange rate. The paper concludes that the current order is well-conceived because cross-border labour mobility is limited, Canadian money wages and prices are sticky, and the real exchange rate between Canada and the United States is subject to real shocks. Among the fixed exchange rate options, all of which are inferior to current arrangements, a full monetary union is judged the most economically viable, though politically illiberal, while a pegged rate seems to provide an untrustworthy basis for a coherent monetary order. Résumé On aurait tort d’examiner les mérites respectifs, pour le Canada, de différents régimes de change sans égard aux autres aspects du régime monétaire. Pour qu’un régime monétaire soit cohérent, il doit répondre à trois critères : i) la banque centrale doit avoir un objectif bien défini en matière de politique monétaire; ii) elle doit être en mesure de le réaliser; iii) cet objectif doit servir de point d’ancrage aux attentes du secteur privé. En outre, pour que ce régime soit « libéral », un dernier
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