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Perhaps I may play devil's advocate and attempt to defend Mr. Drummond's claim. It is certainly the case (under perfectly competitive markets, of course) that prices and productivity are inversely related. That is, 1% increase in productivity should lower prices by 1%, all else equal. Now, in order to prevent arbitrate trading in goods between Canada and the US, it must that a Canadian would pay the same amount for a good purchased domestically and a similar one purchased in the US and shipped to Canada. The exchange rate may serve this purpose. So, Mr. Drummond may have meant the following: Canadian productivity is 0.85 of US productivity, which means American prices are 0.85 of Canadian ones, on average, and price differentials impact nominal exchange rates directly. So, price differentials may be the link between productivity and exchange rates.

I noticed that, too, and thought it was quite odd.

"Perhaps I may play devil's advocate and attempt to defend Mr. Drummond's claim. It is certainly the case (under perfectly competitive markets, of course) that prices and productivity are inversely related. That is, 1% increase in productivity should lower prices by 1%, all else equal. Now, in order to prevent arbitrate trading in goods between Canada and the US, it must that a Canadian would pay the same amount for a good purchased domestically and a similar one purchased in the US and shipped to Canada."

You have managed to postulate that Canada is both an autarky and a small, open economy in the same paragraph.

He works for a Bank? He has probably been under a lot of pressure lately. (But the only productivity that counts anyway is productivity in tradeables, that is something quite different than economy wide productivity.)

(P.S. The above comment is about looking at the 85% measure - it could be irrelevant ANYWAY even if he hadn't forgotten about the real/nominal thing.)

I remember going to canada in the 1960s... the exchange rate ,then, was explained as the action of taxes...
and when I went there, the tax gobbled up the difference in price ..

Maybe he meant to say: "Given that Canadian wages are about the same as US wages (dollar for dollar)...."?

But we all say daft things at times, especially under the pressure of an interview.

What I find puzzling about the Canada/US exchange rate is that it has stayed close to unity over such a long period. You would have thought the two currencies might have drifted further apart, given the different histories of the two countries. I don't think this is an accident, and I think it is due to the two currencies having the same name. If people, and monetary policymakers, somehow have the idea at the back of their minds that "a dollar is a dollar", then somehow an exchange rate of unity seems to act as some sort of focal point. Just think of the news stories when the Canadian dollar went above the US dollar recently. One is a magic number.

If we're assuming that there is a long-run equilibrium for exchange rates and that it is determined by price levels then it is not surprising that the exchange rate has stayed in a certain range, assuming that the US and Canadian central banks target the same inflation rate.

Matt H: Yes, and that explanation is good for the last dozen years, but I was thinking about the last hundred or so years, well before inflation targeting. Compare the Can$ with the pound sterling, for example, which historically was worth US$4 (in British slang, the old half-crown coin, worth 1/8 of a pound, was sometimes called "half a dollar") and now fluctuates around US$2. Currencies with different names seem to drift apart over long periods; currencies with the same name seem to stay closer together. (There must be counterexamples). In other words, I don't think the US/Canadian exchange rate has a unit root, but perhaps the US/sterling exchange rate does.

Errr....given that the Canadian government pegged the CAD to the USD for much of that period isn't it a bit meaningless to look at exchange rates prior to 1970 or so?

Even when there was no explicit peg I have no doubt that the Canadian central bank had as (one of?) its target(s) the CAD/USD exchange rate.

Monetary history is by no means my specialty (I'm nothing but a very amateur economist) but that would be my explanation for very long-run stability.

Matt M: Yes, but other currencies were also pegged to the US$ (sometimes via the gold standard) for long parts of their histories. And fixed exchange rate regimes don't seem to last, without devaluations and revaluations. What I'm wondering is whether the fact that the Canadian and US currencies both had the same name reinforced some sort of implicit exchange rate target of unity for the Bank of Canada (or the political process behind monetary policy more generally).

By the way, I do realise that the theory I am advancing is, let's say, highly speculative (or a bit wacko)! I should probably stop, and start talking about house prices, or something more sensible.

Matt M.: I'm not sure what you meant by me postulating both closed and small/open economy. Typical small open economy model merely have relative prices equalized across countries and identically denominated prices equalized as well. Please correct me if I'm wrong, but I don't believe there is a problem with having price level differences in Canadian dollars as long as once converted to a US$ denomination they are equalized - which was my point. This is just my gut feeling, and I will certainly concede the point if you are sure this is not the case.

That being said, my original thought was definitely wrong. I found that the 2005 ICP benchmark study (the best international price comparison study in existence) lists the overall Canadian price level index as 100 (where 100 is equal to the US). So, on average, Canadian dollar denominated prices are equal to the US... which contradicts my original claim. Oh well, it was worth a try.

How you think when the economic crisis will end? I wish to make statistics of independent opinions!

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