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)| false Djoudad, R., C. Gauthier, and P. St-Amant, 2000, “Chocs affectant le Canada et les États-Unis et contribution du taux de change flexible à l’ajustement macro-économique,” paper presented at the 2000 annual Bank of Canada conference on “Revisiting the Case for Flexible Exchange Rates.”
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)| false Macklem, R.T., P.N. Osakwe, M. Hope Pioro, and L. Schembri, 2000, “The Economic Consequences of Alternative Exchange Rate and Monetary Policy Regimes in Canada,” paper presented at the 2000 annual Bank of Canada conference on “Revisiting the Case for Flexible Exchange Rates.”
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Trade integration with Mexico, Canada’s other partner under the North American Free Trade Agreement (1994), has also grown. Canadian barriers to Mexican trade have been reduced; the very few tariffs that remain (except those on a few supply-managed products) are scheduled to be eliminated by 2003. The share of Mexico in Canada’s merchandise trade rose from 1¼ percent in 1993 to 1¾ percent in 1999, and exceeds the share of several industrial countries. (For example, the share of France in Canadian trade stayed unchanged at 1 percent during the period, and that of Germany declined from 1¾ percent to 1½ percent.)
The data in Table 1 are based on merchandise trade, rather than total trade in goods and nonfactor services, because bilateral trade data on nonfactor services were not available for several countries.
In terms of capital flows, in recent years the United States has accounted for just over half of Canada’s direct investment inflows and outflows, roughly the same as the proportion of intra-EU direct investment. The United States accounted for over four-fifths of Canadian equity investment inflows and outflows in 1999, while intra-EU equity flows accounted for about half of the total among EU countries in recent years.
Direct evidence on the costs of exchange rate uncertainty and distorted price signals is not available. One difficulty in measuring the cost of exchange rate risk is that it depends not only on the volatility of the exchange rate, but also on its correlation with other economic variables. Exchange rate flexibility can decrease true economic uncertainty if the exchange rate is used to buffer real shocks.
Currency conversion costs (the bid-ask spreads and commission fees that households and nonbank enterprises pay to banks for foreign currency conversion) for the European Community as a whole were estimated at 0.2-0.3 percent of GDP by the European Commission (1990). The costs of cross-border payments and the in-house currency transaction costs incurred by firms added another 0.1 percent of GDP.
Rose’s study is based on a “gravity” model of bilateral trade flows and controls for a number of other determinants of trade, such as common borders, common language, as well as the endogeneity of exchange rate volatility to trade. His results, however, are largely driven by the behavior of trade flows in a group of developing and/or very small countries (CFA franc countries and a number of small territories and dependencies), and could attribute to a common currency the effects of integration in other policy areas.
Fluctuations in Canadian foreign exchange reserves and central bank interest rates fell markedly after the September 1998 change in foreign exchange intervention policy, when the Bank of Canada decided to stop its previous practice of frequent interventions and instead limit interventions to exceptional cases when the exchange rate was considered to be significantly misaligned and intervention could influence market assessments about the currency’s fundamental value.
This period of policy divergence seems to reflect different assessments of inflation risk as well as the more uncertain fiscal outlook in Canada. In particular, during certain episodes—including in late 1994 and early 1995—one factor that constrained the Bank of Canada’s ability to ease monetary conditions was investors’ concerns about Canada’s large fiscal deficit. The fiscal consolidation that has occurred since then in Canada has contributed to a better policy mix and given monetary policy somewhat greater latitude to operate.
This is consistent with the conclusions of several analyses using vector autoregressions that the supply shocks experienced by Canada and the United States are very asymmetric. Bayoumi and Eichengreen (1994) and Arora (1999) report that macroeconomic shocks in Canada and the United States are asymmetric in several dimensions: their correlation is low and their sizes, as well as the speed of adjustment to them, are significantly different in the two countries.
See Djoudad et al. (2000). By contrast, the Canadian dollar tends to depreciate in response to an increase in the price of energy, as Amano and van Norden (1993) have shown in their estimation of the “Bank of Canada equation” for the exchange rate. This asymmetry, according to the Bank of Canada, could reflect the more energy-intensive production of some Canadian exports.
Further, in regions where integration has progressed beyond the dimensions envisaged in NAFTA, it is possible that the costs of exchange rate flexibility may be higher than in North America.
At the same time, exchange rates among Mercosur members have fluctuated much more than Canada-U.S. exchange rates and at times have generated considerable trade tensions.
The reduction in long-term rates in these countries also reflected other policy measures, especially fiscal consolidation in line with the Maastricht requirements.
Although Canada-U.S. long-term spreads fell during the mid-1990s, the reduction was related mainly to Canada’s fiscal efforts, rather than any expectations of currency convergence.
A close matching of foreign currency liabilities and assets is not always a guarantee against financial disruption in the event of a major exchange rate shift, especially if the bulk of lending is to unhedged borrowers. This does not, however, appear to be the case in Canada.