“Adjusting to a Higher Canadian Dollar”

1. “Adjusting to a Higher Canadian Dollar” Presentation to a conference organized by Global Insight Toronto, Ontario13 September 2005 John Murray Adviser to the Governor

2. OUTLINE • Putting the appreciation in perspective • Economic factors underlying the appreciation • Effects of higher energy prices on the dollar • Regional and sectoral adjustments • Implications for monetary policy

3. Putting the Appreciation in Perspective • Movements in the Canadian dollar over the last 30 years (Chart 1) • Movements of the Canada dollar relative to other currencies (Chart 2 and 3) • Bilateral versus effective exchange rate measures (Chart 4) • The importance of the Can-US dollar exchange rate to Canada

4. Chart 1

5. Chart 2

6. Chart 3

7. Chart 4

8. Economic Factors Underlying the Appreciation • Canada as an important commodity producer and exporter • The “magic” Bank of Canada exchange rate equation • Recent forecast errors and the role of energy (Chart 5) • Other factors that might be at play – global imbalances and productivity • Simulations with modified specifications of our equation (Chart 6 and 7, and Table 1)

9. Chart 5

10. Chart 6

11. Chart 7

12. AvN MAvN BDS HILZ -0.15 (0.03) 2.08 (0.34) -- -0.44 (0.07) 0.09 (0.04) -- -- -0.66 (0.12) -- 0.22 1.26 -0.18 (0.04) 3.29 (0.56) -0.90 (0.47) -0.47 (0.07) -0.17 (0.10) 0.21 (0.04) -- -0.60 (0.13) -- 0.28 1.43  a a' COMt-1 ENERt-1 ENER1t-1 PRODt-1 INTDIFFt-1 USCURt-6 Statistics R2 DW -0.11 (0.03) 2.84 (0.54) -- -0.50 (0.11) 0.01 (0.05) -- -- -0.58 (0.14) 0.64 (0.16) 0.30 1.59 -0.16 (0.04) 2.77 (0.37) -- -0.51 (0.08) -- -- 0.82 (0.32) -0.59 (0.14) -- 0.22 1.36 Table 1 Real Exchange Rate Equations: 1973Q1-1999Q4a a. Newey-West HAC standard errors in parentheses with p-values larger than 0.10 denoted in bold. 1. The real variables ENER and COM are defined as the nominal U.S. dollar price for energy and non-energy commodities divided by the U.S. GDP deflator.

13. The Effects of Higher Energy Prices on the Economy • Potential benefits – higher investment, higher oil revenues, higher tax revenues, higher royalty payments, higher net wealth and an improvement in our terms of trade • Potential costs – reduced household disposable income, higher production costs, lower profits (outside the energy sector), short-run adjustment costs, regional and sectoral imbalances • Canada as a major energy exporter – short term costs versus long-term gains

14. Regional and Sectoral Adjustments • The effects of higher energy and non-energy commodity prices • Favoured regions mainly (but not exclusively) in the west • Favoured sectors mainly (but not exclusively) in the resource and distribution sectors (Chart 8 and 9) • Adjustment response of the tradeables manufacturing sector (Table 2) • How is the adjustment proceeding? Some encouraging signs

15. Chart 8 Effects of Appreciation by Sector

16. Chart 9 Firms Adversely Affected: Main Reactions (56 Firms)

17. Table 2 * Includes sectors that are exposed as net importers.

18. Implications Policy • One country, one monetary policy and one floating currency • Facilitating short-run adjustment, recognizing transitional effects on capacity • Type 1 versus type 2 fundamental forces acting on the exchange rate • Exchange rate movements, the output gap, and inflation

19. References Amano, Robert and Simon van Norden (AvN). 1993, “A Forecasting Equation for the Canada-U.S. Dollar Exchange Rate.” The Exchange Rate and the Economy. Bank of Canada. Bailliu, Jeannine; Ali Dib and Lawrence Schembri (BDS). 2005. “Multilateral Adjustment and the Canadian Dollar.” Presented at the 2005 meetings of the Canadian Economics Association. Helliwell, John; Ramzi Issa; Robert Lafrance and Qiao Zhang (HILZ). 2004. “NEMO: An Equation for the Canadian Dollar.” Presented at the 2005 meetings of the Canadian Economics Association.