exchange rates and exchange rates affect i. ramzi, r. lafrance and j. murray, “ the turning black tide : energy prices and the canadian dollar, ” canadian journal of economics 41, 3 ( 2008 ) : 737 – 59. bis central bankers ’ speeches prices. these variables are not only connected, but more importantly, they move in the desired direction. at times, however, it is not easy to observe them. most of the early empirical work in this area looked at broad macroeconomic variables for evidence of ppp and erpt. for the erpt tests, this typically involved running simple reduced - form equations. a price index, such as the cpi, or a broad measure of import prices ( denominated in the currency of the importer ), would be put on the left - hand side of the equation, as a dependent variable, with the exchange rate and other control variables on the right - hand side, as explanatory variables. using this formula, researchers expected to observe a coefficient on the exchange rate somewhere between zero and 1. a value of 1 would represent complete pass - through, while a value of zero would indicate no pass - through. since the conditions necessary for complete pass - through, such as perfect competition and the absence of any trade barriers or other economic frictions, were unlikely to be satisfied, something between these two extremes was anticipated. in practice, researchers found that, for most countries, the pass - through coefficient was extremely small. this was especially true in the short run, since prices take time to adjust. imported products, and the domestic goods and services that compete with them, were usually found to be more sensitive to exchange rate movements. for this reason, one would expect to see a stronger relationship when looking at import prices alone as opposed to the entire cpi. even here, however, the evidence was often relatively weak. there are a number of possible explanations for this. first, the estimated coefficients were likely biased towards zero because of econometric problems that arise whenever one uses a simple reduced - form equation to estimate a relationship that is inherently endogenous. since prices and the exchange rate are believed to influence each other ’ s behaviour, an obvious simultaneity bias exists. second, it is also possible that effective countercyclical monetary policy and the adoption of an explicit inflation target in countries such as canada have made it harder to observe erpt. some researchers have argued that a credible inflation target makes prices

the negative effect of increased uncertainty on companies ’ export and investment plans. otherwise, it assumes that the trade agreements now in place will continue. the range of possible outcomes is far too wide to incorporate into an economic projection. the four main uncertainties around the outlook for inflation are the same as six months ago, but good progress has been made on some of them. first, in terms of economic potential, our annual review led us to conclude that the economy currently has more capacity than we previously thought. as well, this capacity is growing at a faster pace than we expected. this means we have a little more room for economic demand to grow before inflationary pressures start to build. that said, some firms, particularly exporters, are operating at their capacity limits but are hesitating to invest. this hesitation may be due to trade uncertainty, transportation bottlenecks, shortages of skilled workers or other reasons. regardless, it is limiting growth of our exports and economic capacity. the second source of uncertainty concerns the dynamics of inflation. here, recent data have 1 / 2 bis central bankers'speeches been reassuring. inflation measures, including our various core measures, have been behaving very much as forecast and are consistent with an economy that is operating with very little slack. this gives us increased confidence that our inflation models are working well. the third area of uncertainty is about wages, and data here are also encouraging. wage growth has picked up significantly over the past 18 months, approaching the 3 per cent growth rate one would expect from an economy that is running at capacity. however, the most recent figures are being boosted temporarily by the minimum wage increases in some provinces. the fourth source of uncertainty is the increased sensitivity of the economy to higher interest rates, given elevated levels of household debt. the concern is that as interest rates rise, the share of household income going to service debt will also rise, leaving less to spend on other goods and services, and putting downward pressure on inflation. it will take more time to assess this issue, particularly because new mortgage guidelines are currently affecting the housing market and mortgage lending. however, the growth of household borrowing is slowing, which is consistent with the idea that consumers are starting to adjust to higher interest rates and new mortgage rules. so, as you can see, there has been some progress on these four key areas of uncertainty, particularly the dynamics of inflation and wage growth. this progress reinforces our view that higher interest rates will be warranted over time, although some