ABSTRACT
It was noted earlier that a domestic monetary policy shift is particularly effective with a flexible exchange rate because it encourages a depreciation of the local currency, and this strengthens the trade account. This means that the rest of the world experiences an appreciation which weakens its trade account, with restrictive effects on output and incomes. Viewing this issue in a two-country world consisting of Canada and the United States, a decision by the Federal Reserve System to adopt an expansionary monetary policy will lead to a depreciation of the US dollar which is an appreciation of the Canadian currency. The Canadian trade account will weaken, which causes a decline in total output and incomes in Canada. Monetary policy shifts in the United States produce the opposite or mirror-image impacts in Canada if a flexible exchange rate is being maintained. This is, of course, the exact opposite of the outcome with fixed exchange rates, as discussed in the previous chapter, where an increase in the money supply in the United States imposed a similar monetary expansion on Canada through a balance of payments disequilibrium. This line of reasoning is summarized in the following:
↑∆MSus→↓∆rus→↓∆KAus→↓∆XRus→↑∆XRcn→↓∆(X – M)cn→↓∆Ycn The rather paradoxical conclusion of this discussion is that although floating exchange
rates make domestic monetary policy both independent of balance-of-payments constraints and more powerful, such an exchange rate regime does not insulate a country from foreign monetary shocks. Canada can pursue any monetary policy it wishes, but is still affected by the actions of the Federal Reserve System. A tightening by the US central bank produces expansionary impacts in Canada, which could, of course, be offset with a modest tightening by the Bank of Canada. Canada is free to pursue its own domestic monetary policy goals, but it still must respond to policy shifts by the Federal Reserve System.
