My purpose today is to talk about what I know best—the conduct of monetary policy in Canada. And once again, there were fears of speculative short-term inflows that would make the problem worse. Suppose government policymakers enact a program of unanticipated fiscal stimulus.
Let me make two more points about our inflation-targeting framework. Some argue that for an economy with a foreign sector, monetary policy can create cyclical movements that tend to destabilize an economy. But these options were rejected because they might have invited further speculative pressures.
A fall in the exchange rate will also raise import prices, and assuming elasticity of demand, import spending will fall. Domestic Policy Anchors The floating exchange rate again proved to be useful, because it eased the immediate inflationary pressures. Let me stress a few points about our inflation-targeting system.
It initially causes the capital account to weaken due to lower interest rates, but then later tends to improve it. First introduced inthe target is set jointly by the Bank of Canada and the federal government and reviewed every five years. The other point I want to make is that with these two policy anchors in place, the floating exchange rate can work more effectively for the Canadian economy.
It was clear that the least risky option for Canada was to return to a floating currency. Moreover, with inflationary expectations well anchored, we have found that movements in the exchange rate have much less impact on inflation than in the past. Businesses and individuals can make long-term economic plans with increased confidence about the future.
First, our experience with inflation targets has also allowed us to see the importance of having an anchor for fiscal policy. The Bank of Canada searched for such an anchor throughout the s and s. But there remains much work to do. The outcome of that search was our eventual adoption of inflation targets.
Canada is also one of the few countries to have moved, twice, from a fixed to a flexible currency without either an economic crisis or a rapid depreciation of its currency.
Canada had struggled to stay within this system during the late s. To maintain the fixed exchange rate, the Canadian authorities first intervened on a massive scale. After the adoption of inflation targets inshort-term inflation expectations came down quickly.
An unanticipated increase in the money supply will cause the exchange rate to go down, the financial account to weaken and current account to gain strength. Conclusion In closing, let me say again that Canada has been a pioneer both in having a floating exchange rate and in operating with inflation targets.
Second, and just as important, it could have created a "boom-bust" economic cycle. Given the desire to both maintain stable domestic prices and to avoid an economic boom that could lead to a bust later on, Canadian authorities felt that they had two options.
We should note that investors can buy and sell financial assets such as stocks and bonds more quickly than producers and consumers can sell and buy physical goods.
The authorities looked at a number of alternatives, including the setting of a new higher value for the Canadian dollar against the U. Help reduce excessive aggregate demand Keep inflation down Although the export sector may suffer and jobs might be lost On balance, UK policy makers in recent years have preferred to allow the financial markets to determine exchange rates, rather than manipulate them for policy objectives.
We care just as much about inflation falling below target as we do about inflation rising above target. The Canadian dollar has floated for all but eight years since With the exchange rate allowed to float freely, the Bank of Canada was able to direct monetary policy to the needs of the Canadian economy.
We were able to deal with the inflationary threat posed by rapid economic growth and strong investment flows. Exchange rate policy The exchange rate of an economy affects aggregate demand through its effect on export and import prices, and policy makers may exploit this connection.
Deliberately altering exchange rates to influence the macro-economic environment may be regarded as a type of monetary policy. CFA Level 1 - Effects of Monetary Policy on the Exchange Rate and Balance of Payments.
Examines how changes in monetary policy yield changes in the exchange rate. Also covers the income effects associated with fiscal policy. Monetary policy, which is headed by the Federal Reserve and involves changing the money supply and credit availability to individuals can also affect the exchange rates.
Similar to fiscal policy, it can affect the exchange rates through three paths: income, prices, and interest rates. Financial markets regard exchange rate movements as conveying information about future expected policy rates.
This paper explores the empirical link between conventional and unconventional monetary policy surprises and exchange rate fluctuations at a quarterly frequency.
It examines these links. Special economic conditions require new monetary policy actions. Whether they are a one-time event or they constitute a new way of doing monetary policy will have an impact on the credibility of future policy announcements.
Notes and References  Switzerland had been keeping a minimum exchange rate with the euro since September In Denmark, the Danish krone is part of the Exchange Rate .Download