Why Canada Needs a Flexible Exchange Rate

Increased interest has been shown in recent months regarding the feasibility and potential advantages of a common currency for Canada and the United States. This paper explores the arguments for and against such an arrangement and attempts to determine whether it would offer any significant advantages for Canada compared with the present flexible exchange rate system. The paper first reviews the theoretical arguments advanced in the economics literature in support of fixed and flexible currency arrangements. A discussion of Canada's past experience with the two exchange rate systems follows, after which there is a survey of the empirical evidence published on Canada's current and prospective suitability for some form of fixed currency arrangement with the United States. The final section of the paper examines critically a number of concerns raised about the behaviour of the current flexible exchange rate system. These concerns include its susceptibility to destabilizing speculation; the depressing effect it might have on trade and investment flows; the encouragement it might provide for lax fiscal policies; and the harmful effect it might have on productivity. On the basis of the evidence reviewed in this paper, the author concludes (i) that most of these concerns are either exaggerated or unsubstantiated; and (ii) that a flexible exchange rate continues to offer important advantages for Canada, given the significant differences that distinguish the Canadian and U.S. economies and Canadians’ desire for policy independence.