While the problems in the industrial countries were generally less severe than those in the developing world, they nevertheless caused serious dislocations. Because of differences in the mix of fiscal and monetary policies in the United States compared with Germany and Japan, the U.
In turn, these developments led to an accumulation of very large current account imbalances among these three major countries.
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In these circumstances, the flexible exchange rate system did not perform as well as it might have. But it is not obvious that any other alternative would have been practicable, and I doubt very much that a fixed exchange rate system for the U.
The three major currencies were not the only ones subjected to tensions. Uncertainty about whether and how fiscal imbalances might be corrected, and considerable cross-country differences in actual and expected inflation contributed to major exchange rate pressures among other currencies in the s and early s. As well as causing the United Kingdom and Italy to leave the arrangement, the situation necessitated a widening of the ERM intervention bands. Although it is still early days, conditions in exchange and asset markets have improved considerably since Short-term exchange rate volatility, and even the trend movements in bilateral rates, while still significant, are much smaller than those of the previous two decades.
I believe that this improved perfomance has a lot to do with the convergence we have seen in recent years towards low and stable rates of inflation among the major industrial countries. But progress on the fiscal front has also been essential, helping to reduce risk premiums and stabilize expectations, both with regard to the long-run viability of the fiscal track in many countries and the prospects for continued low inflation. Thus, I would argue that consistently low inflation and improved fiscal positions have brought about more stable, "better behaved" exchange rates, just as theory would have predicted.
This is not to say that exchange rates have remained absolutely stable over the past four years.
Choosing an Exchange Rate Regime The Challenge for Smaller Industrial Countries
They have not. But movements have been more orderly, unlike those of the earlier periods, and most of the observed trends can be explained by the different cyclical positions of countries, the different monetary and fiscal responses, and by changes in world commodity prices.
Exchange rate movements have, at times, appeared to contribute to trade imbalances or exacerbate existing ones. But this should not be interpreted as evidence that markets are pushing rates in the wrong direction. Indeed, imbalances often reflect the fact that economies are at different points of the business cycle. For example, Japan has, until very recently, seen the value of its currency decline, on balance, against the U.
It is obvious that much of the recent movement in the U. Thus, the relatively low yen has been helping to rejuvenate demand in Japan. Meanwhile, a strong U. Of course, it is possible for exchange rates to overreact, even in the benign environment I described a moment ago. But the chances of a serious misalignment are much lower when markets are operating in a climate of greater predictability, provided by a monetary policy grounded in domestic price stability. When exchange rates are not anchored by a credible commitment to price stability, it is difficult, if not impossible, for markets to perform the tasks that are expected of them.
As you know, Canada has been one of the strongest proponents of a flexible exchange rate system. We were the only major industrial country to operate under such a system in the s and early s, and we were the first major country to adopt it again in the s. As a medium-sized open economy that relies on exports of primary commodities more than our principal trading partners, we are vulnerable to external shocks and appreciate the "shock absorber" effect provided by a flexible exchange rate.
Let me tell you briefly how the Canadian economy has performed under the flexible exchange rate system and describe the main forces that have been acting on our exchange rate. During this time, annual inflation rates in Canada exceeded those in the United States by about one per cent, on average. While on a yearly basis this may not sound like much, cumulatively the differential was rather significant and can explain most of the trend depreciation in the Canada-U. As for the cyclical swings that accompanied the trend depreciation of the Canadian dollar, they reflected a number of factors.
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Among these, the most significant has been the variability in the world prices of primary commodities, which remain an important component of our exports. But the most worrisome factor during the s and s was the growth of the fiscal deficit and the destabilizing effect that this had on financial markets, including the foreign exchange market.
Rising public debts and deficits contributed importantly to the risk premiums in interest rates on Canadian dollar assets and were the catalyst, if not the cause, of unsettling episodes in , , and Fiscal policy concerns, at times coupled with political uncertainty, proved to be a volatile mix and led to serious financial market turbulence and speculative pressures, complicating the task of monetary policy.
Fortunately, the situation has recently improved considerably. Inflation in Canada is stable, at its lowest level in decades. And it has been somewhat below that in the United States since But other factors also tend to favour a stronger Canadian dollar. First, deficit reduction by Canadian governments has eased the uncertainty that had pervaded financial markets, thereby shrinking risk premiums in interest rates and reversing the currency weakness caused earlier by these premiums.
Second, Canadian industries are in a stronger competitive position than they have been for years, and this has contributed to a sharp reduction of the persistent deficit in the current account of our international balance of payments.
Choosing an Exchange Rate Regime : The Challenge for Smaller Industrial Countries
Third, primary commodity prices are firm and likely to move higher with the pickup in global economic activity. In light of all this, it is not surprising that several analysts, as well as the Bank of Canada, expect a stronger Canadian dollar in the future and think that the currency is currently undervalued relative to its longer-term fundamentals.
Why, then, has the Canadian dollar not been stronger? The explanation lies mainly in the different cyclical positions of the Canadian and U. The more accommodative monetary conditions pursued in Canada during the past two years have been consistent with the needs of an economy characterized by considerable excess capacity and an inflation rate that has tended to be in the lower half of the current 1 to 3 per cent target range.
Thus, lower interest rates and a relatively low Canadian dollar have been temporarily appropriate for economic reasons.
While no central bank ever wishes to have a weak currency, since late , the Bank of Canada has encouraged easier monetary conditions—conditions that, at times, have taken the form of lower interest rates and a somewhat softer dollar. Put another way, the Bank did not purposely push the dollar lower, but simply aimed for the path of monetary conditions that seemed appropriate given sluggish domestic economic conditions. The particular mix of interest rate and exchange rate adjustments necessary to achieve the desired path of monetary conditions is not under the direct control of the Bank of Canada.
It is essentially determined by the markets. However, the Canadian economy has been gathering momentum lately, and prospects are good for continued robust expansion through and into , in response to the substantial past monetary easing. With the margin of excess capacity in the economy still fairly wide, there is ample room for strong growth in coming quarters without a resurgence of inflation. However, as the slack is absorbed, the Bank will need to pursue less stimulative monetary conditions, consistent with a durable, low-inflation economic expansion.
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