Question

While Monetary Policy can have three “goals,” it only has one “tool” to implement policy. That makes it particularly difficult for the central bank – the Bank of Canada – to manage any more that “one” goal.

In Canada’s case, the Bank of Canada’s “goal” is to maintain an inflation-Target of 2 percent per year within an operating band of 1 to 3 percent. As a result, Canada maintains a FLEXIBLE or FLOATING current regime in international markets.

i.  HOW and WHY maintaining the Bank of Canada’s Inflation-Target goal would (1) Make a Canadian FIXED EXCHANGE REGIME problematic or difficult to maintain; and (2) What would be the impact on the Canadian Dollar Exchange Rate if Monetary Policy was to reduce the key policy rate?

Answer 1

- We have been informed that the Bank of Canada’s “goal” is to maintain an inflation-Target of 2 percent per year within an operating band of 1 to 3 percent.

- The selection of the currency regime whether fixed or flexible on a country’s ability to exercise independent monetary policy.

- If the exchange rate were fixed, then any attempt to increase interest rates to undertake independent monetary policy to control inflation would result in a potentially unlimited inflow of capital because funds would seek the higher return. The central bank would be forced to buy foreign currency and sale domestic currency to maintain the fixed exchange rate. The excess of reserves and increase in the domestic money supply would put downward pressure on domestic interest rates until rates were forced back to equality, negating the initial policy measures.

- SO yes the it will make the Canadian fixed exchange remine difficult to maintain. Independent monetary policy is not possible if exchange rates are credibly fixed and currencies are fully convertible