Canada's Pioneering Experience with a Flexible Exchange Rate in the 1950s: (Hard) Lessons Learned for Monetary Policy in a Small Open Economy

Abstract

This paper revisits Canada’s pioneering experience with a flexible exchange rate over the period 1950–62. It examines whether the floating rate was the best option for Canada in the 1950s by developing and estimating a New Keynesian small open-economy model of the Canadian economy. The model is then used to conduct a counterfactual analysis of the impact of different monetary policies and exchange rate regimes. The main finding is that the flexible exchange rate helped reduce the volatility of key macroeconomic variables. The Canadian monetary authorities, however, did not understand all of the implications of conducting monetary policy under a flexible exchange rate and a high degree of capital mobility. The paper confirms that monetary policy was more volatile in the post-1957 period and Canada’s macroeconomic performance suffered as a result.