The Exchange Rate and Canadian Inflation Targeting

The author provides a non-technical explanation of the role played by the exchange rate in Canada's inflation-targeting monetary policy. He reviews the motivation for inflation targeting and describes the monetary transmission mechanism. Though the exchange rate is an integral component of the transmission mechanism, the author explains why it is not a target for monetary policy. He provides a simple taxonomy for exchange rate movements, distinguishing between movements associated with direct shocks to aggregate demand and those unrelated to such direct shocks. He explains the importance to monetary policy of determining the cause of any given movement in the exchange rate, and of determining the net effect on aggregate demand. The author also describes Canadian monetary policy during the 2003-04 period, a time when the Canadian dollar appreciated sharply against the U.S. dollar.