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4. The Exchange Rate, Productivity, and the Standard of Living

Principles of Macroeconomics (with Xtra!)

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17 B ANK OF C ANADA R EVIEW W INTER 1999–2000 The Exchange Rate, Productivty, and the Standard of Living Robert Lafrance and Lawrence L. Schembri, International Department Canada’s standard of living relative to the United States as well as the Canadian-U.S. dollar exchange rate have both declined over the 1990s. This coincident occurrence has led some observers to maintain that these two key economic variables are intimately and causally related. Indeed, they argue that Canada’s flexible exchange rate is responsible for the relative fall in the standard of living and that the decline could have been avoided had Canada been on a fixed exchange rate over this period. This article explores the various channels through which these two variables could be related based on economic theory and empirical evidence. The main channels through which the standard of living and the exchange rate may be related are productivity and the terms of trade. Although this article focuses on the possible links between productivity and the exchange rate, the relation- ship between the terms of trade and the exchange rate is also examined. The authors conclude that exogenous forces— notably a decline in the world prices of commodities and weak demand for domestic output—were affecting both Canada’s standard of living and the exchange rate and that the flexible exchange rate regime itself did not play an independent role in the relative decline in Canada’s standard of living. country’s standard of living is usually measured by per capita income or expenditure. 1 The standard of living is determined essentially by three factors: the country’s supply of factors of production per capita (e.g., physical and human capital, labour, and, especially in Canada’s case, natural resources) and their rate of utilization; the productivity of the employed factors, which reflects the efficiency of the processes used to transform these factors into final output; and the country’s terms of trade, which represent the relative value of the country’s exports in terms of goods and services that it imports from the rest of the world. (See Box 1 for a discussion on measuring productivity.) Generally speaking, a country’s standard of living will be higher, the greater the size and quality of its supply of productive factors relative to its population, the higher the rates at which these factors are employed, the more productive these factors are in generating output, and the more valuable its domestic exports are in world markets. 2 To explain the decline in Canada’s 1. In this article, only the conventional real income- or expenditure-based definition of standard of living is used, instead of broader definitions that would include other economic and non-economic factors (e.g., wealth, pollution, and income inequality). National income is typically measured by GDP (even though GDP is technically a measure of national output).
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