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A modest proposal for monetary policy

The Bank of Canada needs to pay more attention to exchange rates

by Thomas J. Courchene

The Bank of Canada’s policy of “inflation targeting,” which seeks to keep the rate of inflation between 1 and 3 per cent, has the support of an overwhelming majority of Canadian academic and business economists. The monetary instrument to deploy when the inflation rate is outside of this desired range is short-term interest rates – raise them when inflation is above the target range and lower them when below. A key if unstated corollary is that the value of the loonie is to be allowed to float freely – the exchange rate is ignored in calibrating monetary policy.

In contrast, Robert Mundell, Canadian Nobel laureate in economic sciences, argued that the exchange rate is the most important price in the Canadian economy. Following upon Mundell, the thesis in what follows is that ignoring the international value of the loonie in the framing of Canadian monetary policy, and in particular ignoring the loonie’s dramatic swings vis-à-vis the U.S. dollar over the last two decades, is questionable if not foolhardy. While there are times when a depreciation of the loonie is to be welcomed on economic grounds, Canada’s experience has too often involved dramatic overshooting of the currency, both upward and downward, which is unhelpful in both the short and the longer term.

The underlying issue is straightforward: the Canadian currency area is too small and too open for a freely floating exchange rate to accommodate both a world-class manufacturing sector and a global energy superpower. As figure 1 reveals, Canada’s exchange rate appreciated and depreciated more or less in lockstep with increases and decreases in global crude oil prices between 1994 and 2013. Readers will recognize this as the proverbial Dutch Disease – the global demand for energy drives up Canadian energy prices and export volumes, which in turn serves to appreciate the loonie and devastate the export potential of the Canadian manufacturing sector.


This is particularly problematic in the Canadian federal context since manufacturing and resources are located in different regions/provinces. Intriguingly, while the appreciation clearly damages manufacturing-intensive Ontario, it may create challenges for energy-intensive Alberta as well. Since global energy prices are set in U.S. dollars, if the percentage appreciation of the loonie equals the percentage rise in energy prices then the Canadian dollar value of a barrel of exported oil is unchanged. Phrased differently, an energy price–driven exchange rate serves to stabilize the energy sector, but it destabilizes the manufacturing sector. This approach is more than a bit strange in terms of

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About the Author

Thomas J. Courchene
Thomas J. Courchene is Emeritus Professor of Economics at Queen’s University and has written extensively on various aspects of economic policy.


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