The Exchange Rate and Canadian Inflation Targeting

This paper provides a non-technical explanation of the role played by the exchange rate in Canada’s inflation-targeting monetary policy. We begin by reviewing the motivation for inflation targeting and discussing the monetary transmission mechanism. Though the exchange rate is an integral component of the transmission mechanism, we explain why it is not a target for monetary policy. We then provide a simple taxonomy for exchange-rate movements, distinguishing between changes associated with direct shocks to aggregate demand and changes unrelated to such direct shocks. We explain the importance to monetary policy of determining the cause of any given exchange-rate change, and also of determining the net effect on aggregate demand. We illustrate the arguments with a brief discussion of Canadian monetary policy in the 2003-04 period