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«Abstract This paper presents an analysis of the relationship between Canadian monetary policy and real and nominal exchange rate movements vs. the ...»

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Small-Open-Economy Monetary Policy and

Real and Nominal Exchange Rates:

The Canadian Case

John E. Floyd

University of Toronto1

April 29, 2014


This paper presents an analysis of the relationship between Canadian monetary policy and real and nominal exchange rate movements vs. the U.S. using

broad-based theory and 1974-2010 quarterly data. Contrary to the situation

in the United States, real interest rates relevant for investment in Canada are

determined in the world market and are not controlled by the central bank.

Major continuing effects of real shocks on Canada’s real exchange rate render a fixed exchange rate unacceptable. Given trivial observed effects of monetary shocks on the real exchange rate, the conclusion is that the Bank of Canada avoids exchange rate overshooting by following an ‘orderly markets’ approach that generates results virtually identical to U.S. policy. It is argued that such an approach arises automatically as a consequence of the Bank’s continuing maintenance of a specific target for the overnight borrowing rate. Significant direct exchange rate pressures would be required to respond to U.S. based international crises or inappropriate domestic inflation expectations. These pressures can be produced in part by changes in the Bank’s target overnight rate but may also require additional carefully engineered changes in the stock of base money that lead to real exchange rate changes which put pressure on aggregate demand. Otherwise, the orderly markets framework associated with a given level of the overnight rate has important advantages.

342 Max Gluskin House, Toronto, M5S1A1, floyd@chass.utoronto.ca (email), 416Office), 419-992-5143 (Cell), 416-769-8245 (Home), 416-978-6713 (Fax). All data and other files referred to in this paper can be found at the author’s website http://homes.chass.utoronto.ca/floyd/cmpdat.html. The theory and evidence presented here are extensions and refinements of material presented in the author’s recent book, John E. Floyd, Interest Rates, Exchange Rates and World Monetary Policy, Springer, 2010.

I: Introduction This study analyzes the relationship between Canadian monetary policy and the movements of Canada’s real and nominal exchange rates with respect to the United States and, less directly, with respect to the rest of the world.2 The focus is upon Canada because it is an excellent venue for small-open-economy analysis, being a major trading partner with the large United States economy to the south. The analysis here encompasses, extends and broadens a range of more narrowly-focused theoretical efforts that dealt with specific details relating the real exchange rate to utility functions in endowment models or relating expected changes in real exchange rates to real interest rate differentials in asset pricing models, and also efforts that dealt with specific individual sources of real exchange rate fluctuations in models with traded and non-traded goods or with productivity shocks and market frictions.3 Section II develops a broad-based theory to form the basis for subsequent empirical analysis that can reflect directly on the practical implementation of monetary policy in small open economies like Canada. The model suggests Many thanks are given to John Murray and Bob Amano of the Bank of Canada for their insightful comments on an earlier draft of this paper.

See, for example, William D. Lastrapes, “Sources of Fluctuations in Real and Nominal Exchange Rates,” Review of Economics and Statistics, 74, 1992, 530-539, David Bachus and Gregor W. Smith, “Consumption and Real Exchange Rates in Dynamic Economies with Nontraded Goods,” Journal of International Economics, 35, 1993, 297-316, Robert A. Amano and Simon Van Norden, “Terms of Trade and Real Exchange Rates: The Canadian Evidence,” Journal of International Money and Finance, 14, 1995, 83-104, Michael B. Devereux, “Real Exchange Rates and Macroeconomics: Evidence and Theory,” Canadian Journal of Economics, 30, 1997, 773-808, Pierre-Richard Ag´nor, “Capital Flows, External Shocks and e the Real Exchange Rate,” Journal of International Money and Finance, 17, 1998, 713-740, Bill Frances, Iftekhar Hasan and James R. Lothian, “The Monetary Approach to Exchange Rates and the Canadian Dollar Over the Long Run,” Applied Financial Economics, 11, 2001, 475-481, Yu Sheng and Xinpeng Xu, “Real Exchange Rate, Productivity and Labor Market Frictions,” Journal of International Money and Finance, 30, 2011, 587-603, and Ron Alquist and Menzie D. Chinn, ” Conventional and Unconventional Approaches to Exchange Rate Modelling and Assessment,” International Journal of Finance and Economics, 13, 2008,2Tino Berger and Bernd Kempa,”Taylor Rules and Canadian-US Equilibrium Exchange Rate,” Journal of International Money and Finance, 31, 2012, 1060-1075, Rokon Bhuiyan, ”Monetary Transmission Mechanism in a Small Open Economy: A Bayesian Structural VAR Approach, Canadian Journal of Economics, 45:3, 2012, 1037-1061, Amir Kia, ”Determinants of the Real Exchange Rate in a Small Open Economy: Evidence from Canada,” Journal of International Markets, Institutions and Money, 23, 20‘13, 163-178, For a tiny rigorous precursor of the model developed here, see Peter Neary, “Determinants of the Equilibrium Real Exchange Rate,” American Economic Review, 78, 1988, 210-215. And for a broader model applied to exchange rate policy in developing countries, see Sebastian Edwards, Real Exchange Rates, Devaluation and Adjustment, MIT Press, 1989. Finally, the very first real exchange rate analysis of the sort conducted here can be found in John W. Johnston, “Real and Nominal Exchange Rate Determination in a Small Open Economy: An Empirical Investigation of the Canadian Case,” University of Toronto Ph.D Thesis, 1993.

and incorporates a wide range of factors determining Canada’s real exchange rates with respect to the United States and the world at large and outlines the short-run and long-run effects of monetary policy on nominal and real exchange rates. It finds some specific implications of real and nominal exchange rate shocks for the choice of a fixed as opposed to flexible exchange rate regime and for the conduct of monetary policy under flexible exchange rates. An important consideration arising within the theory is the possibility and implications of exchange rate overshooting.4 Implications of the theory are tested empirically in Section III. The major factor affecting Canada’s real exchange rate with respect to the United States is found to be changes in the flow of world real investment into and out of Canada as compared to its southern neighbor. A lesser, but important factor is changes in world energy prices. The effects of Canadian and U.S. real income are those predicted by the Balassa-Samuelson hypothesis, with short-run employment effects operating, as would be expected, in the opposite direction.5 And effects of world commodity prices and Canadian terms of trade changes turn out to be important as well. A very important empirical result is that unanticipated monetary shocks, despite the possibility of overshooting, have no measurable effects on short-run real and nominal exchange rate changes, a fact that has important implications for interpreting the on-going conduct of monetary policy.

Section IV brings the theory and evidence together to reach an understanding as to how monetary policy in a country like Canada should be conducted.

Given the evidence that can be extracted as to what the Bank of Canada is in fact doing, the general conclusion emerges that it is doing things correctly, automatically following a virtually identical policy to that in the United States, by ensuring orderly foreign-exchange markets via. continual maintenance of a target level of the overnight rate at which it lends and borrows reserves to and from the Canadian banking system. Although the United States authorities purport to operate on real interest rates and thereby on domestic investment, that option is basically not available to a small country like Canada embedded in a world capital market. But control of overnight borrowing rates in Canada nevertheless provides a good method of influencing the expected domestic ination rate, which turns out to be crucially important for policy. And it also enables the Bank to change the profitability of holding, and thereby induce gradual adjustments of, bank reserves with eventual effects on the stock of base money. In the process, particular interest interest rates at which the commerFor an interesting discussion of this issue, see Mathias Hoffman, Jens Sondergaard and Niklas J. Westelius, “The Timing and Magnitude of Exchange Rate Overshooting,” Deutsche Bundesbank Discussion Paper 28, 2007.

B. Balassa, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy, 72, 1964, 584-96, and Paul A. Samuelson, “Theoretical Notes on Trade Problems,” Review of Economics and Statistics, 46, 1964, 145-154.

cial banks loan funds to specific borrowers may also be affected while domestic portfolio equilibrium is being re-established through the purchase or sale of assets in international markets with ultimate effects on the value of the Canadian dollar. Straight open-market operations by the Bank of Canada, on the other hand, will lead directly and almost exclusively to portfolio adjustment pressures on the dollar’s value.

While nominal exchange rate adjustments, and associated short-run real exchange rate changes thus turn out to be an important monetary policy instrument for a small-open-economy like Canada, potentially observable direct short-term pressure by the Bank of Canada on the exchange rate through base money stock adjustments is desirable only in a situation of major world crisis reflected in the U.S. or under circumstances where the Canadian inflation rate is continually deviating substantially from an appropriate level. The empirical evidence uncovered here makes it possible to arrive at a rough estimate of how far the Bank of Canada would have to change the nominal and real exchange rates, under the critical circumstances above, to move the unemployment rate in a desired direction by one percentage point, with the real exchange rate and employment returning to their long-run equilibrium levels as inflation expectations and wages and prices eventually adjust. An obvious related conclusion is that, for political reasons, the Bank of Canada should not publicly claim credit for any short-run real and nominal exchange rate changes that economic conditions require it to engineer.6

–  –  –

˜ where PTD is the foreign currency price of the domestic traded component of output. The real exchange rate of Canada with respect to the United States will thus depend on the ratio of the prices of the non-traded components of Canadian output to the prices of the non-traded components of U.S. output and on the prices of the Canadian traded output components relative to the prices of the U.S. traded output components.

We can expect Canada’s real exchange rate with respect to the U.S. to rise when the prices of commodities and energy rise in international markets, relative to the prices of other goods, because production of these traded commodities represents a higher proportion of Canadian output than United States output.

More broadly, we would expect that a rise in Canada’s terms of trade with respect to the rest of the world relative to the U.S terms of trade with the rest of the world would also lead to an increase in the real exchange rate. And, according to the Balassa-Samuelson hypothesis, we would also expect the real exchange rate to rise in response to an increase in domestic relative to foreign full-employment income.8 As income rises so do real wages and the relative increase in real wages increases the cost of producing the non-traded components of domestic output relative to the cost of producing foreign non-traded output components. By contrast a temporary increase in output and employment in Canada relative to the U.S. will increase the supply of Canadian relative to U.S. output, lowering its relative price. A further obvious factor causing the real exchange rate to rise will be shifts of demand of domestic residents from Even the classic non-traded good, haircuts, has traded components because hair stylists will be using clippers, chairs and other things that can be imported from abroad. And a classic traded good like wheat will have cost components representing domestic labour required to arrange storage, transport and sale.

See reference in footnote 5 above.

goods with low non-traded components to those with high non-traded components. While shifts of this sort are extremely difficult to measure, one obvious measurable factor might be the share of government expenditure in domestic output since there are obvious political pressures on government to channel its spending as directly as possible to domestic residents.

Finally, we can expect that a decision of international investors, in response to new technological developments, to increase their real investment in Canada relative to their investment in United States will produce an increased demand for the non-traded components of Canadian as compared to U.S. output as the Canadian-employed capital stock expands relative to that in the U.S., requiring a higher relative price of Canadian output to achieve equilibrium. This rise in the real exchange rate will have to reduce the current account surplus, or increase the current account deficit, sufficiently to offset the increase in net borrowing abroad. This follows from the fact that domestic income, denoted by Y, can be divided into the components

Y = C + I + BT + DSB (5)

where C is total private plus government expenditure on consumption, I is total private plus government expenditure on investment, BT is the balance of trade in goods and services excluding the services of capital, and DSB is the debt service balance which equals income from foreign employed capital owned by domestic residents minus income from domestically employed capital owned by foreigners. These variables should be viewed as real magnitudes. Subtraction of total consumption and investment from both sides produces the expression

S − I = CAB (6)

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