Page 148 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

International Trade and Finance

Notes The month-to-month changes in official foreign exchange reserves were much more variable than
the month to month changes in base money, particularly in 1968, and reserves grew very sharply in
early 1970. How do we explain this ?
The fact that reserves were more variable than base money suggests that these changes in official
reserves were driven in considerable part by changes in the opposite direction in the domestic source
component. Since H equals R plus Dsc , greater variability of R than H can only result from variability
of Dsc in the opposite directions. An ordinary least squares regression of the month-to-month changes
in foreign exchange reserves on the month-to-month changes in base money indicates no statistically
significant relationship between them. The slope coefficient is negative with a P-Value of .23 ---
indicating a 23 percent chance of observing a negative value of the magnitude observed purely on the
basis of random chance when the true value is in fact zero---and the R-Square is only .01.
We have to conclude that much of the variability of the stock of official reserves was the result of the
Bank of Canada’s manipulation of the domestic source component but we should not venture a
conclusion as to why the Bank was doing this without much more careful study. It is well-known
that the Canadian Government abandoned the fixed exchange rate in mid-1970 in order to allow the
government to control increasing upward domestic inflationary pressure which it was powerless to
control under a fixed exchange rate. Accordingly, the observed escalating increases in the stock of
official reserves in 1970 may well be the result of a fruitless attempt by the Bank of Canada to get a
handle on domestic inflation by reducing the growth of the domestic source component of high-
powered money. The only way to get control was to let the Canadian dollar float freely in the
international market---only then could monetary policy become effective.
With respect to Canada’s abandonment of the fixed exchange rate, it is useful to look at the
movements in her real exchange rate with respect to the U.S., plotted in Figure 12.3.

108 106

Index : 1963-66 = 100 104 102

100

98

1964 1966 1968 1970 1972
Monthly
Figure 12.3 : Canadian Real Exchange Rate With Respect to United States

Recall from the definition of the real exchange rate that
P = Q П P* .
If the government fixes the nominal exchange rate, the Canadian price level will vary up and down
relative to the price level in the U.S. in response to movements in the equilibrium level of the real
exchange rate Q arising from shifts in desired exports relative to imports, shifts in domestic relative
to U.S. consumption and investment, changes in commodity prices, and so forth. When the exchange
rate is fixed the Bank of Canada can not use monetary policy to avoid these price level changes.
Notice from Figure 12.3 that the real exchange rate increased by about 3.5 percent between mid-1962
and mid-1967--- an average rate of of increase of a bit less than 3/4 of a percent per year. Then
between mid-1967 and mid-1970 the real exchange rate fell by about the same amount---at an average

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