3. Real Exchange Rate Indexes for the Canadian Dollar

Principles of Macroeconomics (with Xtra!)

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19 BANK OF CANADA REVIEW AUTUMN 1999 Real Exchange Rate Indexes for the Canadian Dollar Robert Lafrance and Pierre St-Amant, International Department Real exchange rate (RER) indexes for Canada measure the movement of Canadian prices against foreign prices, expressed in a common currency. Two key elements in calculating an RER index are the weights employed and the price or cost indicators selected. In principle, the best weighting systems are those that take account both of bilateral trade between countries and of the competition that their businesses give each other in third markets. Because one partner—the United States—weighs so heavily in Canada’s trade, the weighting system generally makes little difference in calculating Canadian RER indexes. When exchange rates for some of our other trading partners are fluctuating sharply, however, it is useful to keep an eye on indexes that cover several countries. In practice, the most important choice to make is the price or cost indicator on which to build the RER index. Theory and empirical evidence alike favour RER indexes calculated on the basis of unit labour costs (ULC). Yet ULC data are published infrequently and late, and they typically cover only the manufacturing sector. Economic policy-makers should, therefore, consider RER indexes constructed with other indicators as well. ith the Canadian economy becoming increasingly open to foreign markets, interest has been growing, for some years, in the competitiveness of Cana- dian businesses. Because competitiveness cannot be measured directly, it has been necessary to find ways to monitor its performance indirectly. A favourite method used by researchers and by various national and international agencies has been to devise real exchange rate (RER) indexes. This article offers both a theoretical and a practical analysis of the merits and shortcomings of the different weighting systems and price indicators used in preparing RER indexes and compares various RER indexes that have been calcu- lated for the Canadian economy. 1 Definition and Meaning RER indexes are measures of how domestic prices (costs) move against foreign prices (costs), when they are expressed in a common currency. They can be written in the following manner: where represents an index of domestic prices (costs) in Canadian dollars; , represent price (cost) indicators for countries whose businesses compete with Canadian firms; , represent bilateral exchange rates of the Canadian dollar against the cur- rencies of those countries; and , are the relative 1. Some of the ideas expressed in this article can be found in Lafrance et al. (1998). Lafrance (1988) also deals with this subject. W RER P / P 1 E 1 (29 w 1 P 2 E 2 w 2 P n E n w n ⋅⋅ = P P 1 P n E 1 E n w 1 w n
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20 BANK OF CANADA REVIEW AUTUMN 1999 weights of those countries in the index.
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