The Importance of Sound Monetary Policy: Some Lessons for Today from Canada’s Experience with Floating Exchange Rates Since 1950

Abstract

In this paper, we revisit the Canadian experience with floating exchange rates since 1950. Canada was a pioneer in successfully adopting a floating exchange rate during the Bretton Woods pegged exchange rate regime. Since then, most advanced countries have followed the Canadian example. A key finding of our paper based on historical narrative and econometric analysis is that economic performance under floating depended on its monetary policy performance as Milton Friedman originally argued in his seminal 1953 article making the case for floating exchange rates. Canadian monetary policy achieved low and stable inflation once it adopted inflation targeting as a nominal anchor. Also, Canada’s floating exchange rate provided it with a modicum of insulation from external shocks, especially commodity price shocks that influenced both the level and volatility of the real exchange rate over the past three decades. The Canadian experience with floating (along with that of other small open economies such as Australia, New Zealand and Sweden) combined with inflation targeting became a global model for sound monetary policy.