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International Financial Crises and Flexible Exchange Rates: Some Policy Lessons from Canada

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Listed:
  • John Murray
  • Mark Zelmer
  • Zahir Antia

Abstract

This paper examines the behaviour of the Canadian dollar from 1997 to 1999 to see if there is any evidence of excess volatility or significant overshooting. A small econometric model of the exchange rate, based on market fundamentals, is presented and used to make tentative judgments about the extent to which the currency might have been systematically over- or undervalued. Three major conclusions emerge from the analysis. First, movements in world commodity prices and Canada-U.S. interest rate differentials can account for most of the observed variation in the value of the Canadian dollar. Any deviations that were recorded between actual and predicted values of the exchange rate were generally small and short-lived, suggesting that destabilizing speculative behaviour did not play a very important role in recent market developments. Second, while it is possible to explain most of the past movements in the Canadian dollar using a simple exchange rate equation, its ability to predict future movements in the exchange rate is limited due to the inherent instability of the fundamental variables guiding its behaviour. Exchange rate predictions, in short, are only as accurate as the forecasts of future commodity prices and interest rates. Third, it appears that periods of market turbulence are often dominated by fundamentalists as opposed to noise traders and are triggered typically by large external shocks. Monetary authorities should therefore be wary of resisting any movements in the exchange rate, since they are often part of a necessary and unavoidable adjustment process. Aggressive foreign exchange market intervention and other monetary policy actions designed to stabilize the exchange rate could easily prove counterproductive and subvert market efficiency.

Suggested Citation

  • John Murray & Mark Zelmer & Zahir Antia, 2000. "International Financial Crises and Flexible Exchange Rates: Some Policy Lessons from Canada," Technical Reports 88, Bank of Canada.
  • Handle: RePEc:bca:bocatr:88
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    References listed on IDEAS

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    1. Vigfusson, Robert, 1997. "Switching between Chartists and Fundamentalists: A Markov Regime-Switching Approach," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 2(4), pages 291-305, October.
    2. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
    3. Philippe Muller & Mark Zelmer, 1999. "Greater Transparency in Monetary Policy: Impact on Financial Markets," Technical Reports 86, Bank of Canada.
    4. John Murray & Simon van Norden & Robert Vigfusson, 1996. "Excess Volatility and Speculative Bubbles in the Canadian Dollar: Real of Imagined?," Technical Reports 76, Bank of Canada.
    5. Rudiger Dornbusch, 1979. "Monetary Policy Under Exchange Rate Flexibility," NBER Working Papers 0311, National Bureau of Economic Research, Inc.
    6. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
    7. Pierre St-Amant & David Tessier, 1998. "Tendance des dépenses publiques et de l'inflation et évolution comparative du taux de chômage au Canada et aux États-Unis," Staff Working Papers 98-3, Bank of Canada.
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    Cited by:

    1. David Laidler & William B.P. Robson, 2004. "Two Percent Target: The Context, Theory, and Practice of Canadian Monetary Policy since 1991," C.D. Howe Institute Policy Studies, C.D. Howe Institute, number 20041, January.
    2. repec:dau:papers:123456789/10086 is not listed on IDEAS
    3. Céline Gauthier & David Tessier, 2002. "Supply Shocks and Real Exchange Rate Dynamics: Canadian Evidence," Staff Working Papers 02-31, Bank of Canada.
    4. B. Moazzami & F. J. Anderson, 2003. "Long-term trend and short-run dynamics of the Canadian dollar: an error correction modelling approach," Applied Economics, Taylor & Francis Journals, vol. 35(13), pages 1527-1530.
    5. Toni Gravelle & Richhild Moessner, 2001. "Reactions of Canadian Interest Rates to Macroeconomic Announcements: Implications for Monetary Policy Transparency," Staff Working Papers 01-5, Bank of Canada.
    6. Jamie Armour & Ben Fung & Dinah Maclean, 2002. "Taylor Rules in the Quarterly Projection Model," Staff Working Papers 02-1, Bank of Canada.

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    More about this item

    Keywords

    Exchange rates; Exchange rate regimes;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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