Understanding the Volatility of the Canadian Exchange Rate

24 Pages Posted: 21 Feb 2018

See all articles by Martin Eichenbaum

Martin Eichenbaum

Northwestern University; National Bureau of Economic Research (NBER)

Benjamin Kramer Johannsen

Board of Governors of the Federal Reserve System

Sergio T. Rebelo

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: February 8, 2018

Abstract

In this Commentary, we document the nature of the Bank of Canada’s current monetary policy regime by focusing on the following questions: what are the historical determinants of the Canadian–US dollar nominal exchange rate, and can they be used in real-time forecasting applications?

We find that the current real exchange rate is more useful than commodity prices for forecasting changes in the nominal exchange rate. In fact, short-run forecasts based on the real exchange rate are as good as random-walk forecasts according to which the future exchange rate is expected to be the same as today’s. Strikingly, medium- and long-run forecasts based on the real exchange rate are superior to random-walk forecasts. We argue that these findings reflect the fact Bank of Canada and the U.S. Federal Reserve System follow similar inflation-targeting regimes and neither actively manages exchange rates.

A fundamental question is whether Canadian policymakers are satisfied with the current inflation targeting regime. A cost of the current regime is that it allows for very volatile nominal and real exchange rates. A benefit is that consumers and firms can avoid many of the changes in prices and wages that would be required if the nominal exchange rate did not adjust in a flexible manner. In this Commentary, we take no stand on the merits of the current regime. Instead, we highlight the tradeoffs that policymakers face. Evaluating the costs and benefits of those tradeoffs should play an important role in the process leading to the Bank of Canada’s next five-year agreement with the government.

Keywords: Monetary Policy

JEL Classification: E44; E52; E58

Suggested Citation

Eichenbaum, Martin and Johannsen, Benjamin Kramer and Tavares Rebelo, Sergio, Understanding the Volatility of the Canadian Exchange Rate (February 8, 2018). C.D. Howe Institute Commentary No. 502. Available at SSRN: https://ssrn.com/abstract=3121342 or http://dx.doi.org/10.2139/ssrn.3121342

Martin Eichenbaum (Contact Author)

Northwestern University ( email )

2003 Sheridan Road
Evanston, IL 60208
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847-491-8232 (Phone)
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National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Benjamin Kramer Johannsen

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sergio Tavares Rebelo

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Leverone Hall
Evanston, IL 60208
United States
847-467-2329 (Phone)
847-491-5719 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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