david dodge : how the canadian economy is adjusting to global forces remarks by mr david dodge, governor of the bank of canada, to the canadian chamber of commerce, tokyo, 9 june 2005. * * * i am happy to have the opportunity to be back here in tokyo, and to address this group. no matter where you are in the global economy these days, everyone is talking about the same powerful, economic forces. we are all aware of the large and growing financial imbalances in the united states and in asia. rapid growth in emerging - market economies is driving up demand for commodities, and that has pushed up world prices for oil and many non - energy commodities. meanwhile, productivity improvements in some countries and a competitive world environment are lowering the prices for some consumer goods, communications services, and computer equipment. all of these forces are causing significant movement in the exchange rates of key currencies, including a sharp appreciation of the canadian dollar against the u. s. dollar over the past couple of years. in short, these are challenging economic times, not just in canada and japan, but throughout the world. today, i ’ d like to raise two issues. i ’ ll talk first about how the canadian economy has been adjusting in the face of these forces - an adjustment that is being facilitated by the bank of canada ’ s monetary policy framework. then, i ’ ll talk briefly about what needs to be done internationally to help bring about an orderly resolution of global imbalances. adjustments in the canadian economy so let me begin with the canadian economy. i should set the scene by saying just a few words about how the bank of canada conducts monetary policy. the bank of canada act calls on the bank to “ mitigate by its influence fluctuations in the general level of production, trade, prices and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of canada. ” the way we do this is by trying to keep inflation low, stable, and predictable. specifically, we aim to keep the annual rate of consumer price inflation at the 2 per cent midpoint of a 1 to 3 per cent target range. in order to keep inflation at the target, we try to keep the economy operating at full capacity. by this, i mean that we aim for a balance between total demand and supply in the economy. simply speaking, if the demand for goods and services is pushing the canadian economy against the limits of its capacity,

and expanding businesses may require time to put the necessary capital equipment in place to increase productivity. and of course, some firms will go out of business and some people will be unemployed for a period of time. but from a macroeconomic point of view, adjustment can take place with less social and economic cost overall when inflation expectations are well anchored, the economy is operating close to its potential, and a floating exchange rate is helping to absorb external shocks. international adjustments that ’ s a quick look at how the canadian economy is adjusting to global forces. our flexible exchange rate is helping to bring about movements in the real exchange rate, which is what matters in terms of the adjustment process. but this is not the case in all countries. where the nominal exchange rate is fixed, the only way to bring about adjustments in the real exchange rate is through large movements in relative wages and prices. this is theoretically possible if wages and prices are highly flexible, both upwards and downwards. but in practice, wages and prices aren ’ t that flexible. and so when exchange rates are fixed, adjustment can still take place, but it comes at a high cost - through shrinking output and rising unemployment in countries with current account deficits, and eventually through very high inflation in countries with current account surpluses. while this adjustment is costly, it does work, provided countries that are fixing their currencies through foreign exchange intervention are not offsetting the monetary consequences of this by “ sterilizing ” the intervention. this is an important point. when intervention is sterilized, this temporarily prevents the movements in wages and prices needed to bring about the necessary economic adjustment. in these cases, economic adjustment is postponed - in both surplus and deficit countries. but the adjustment and its costs are only delayed, they are not avoided. indeed, the costs typically end up being larger than they would otherwise be, precisely because they have been delayed. the only way to truly minimize the costs of adjustment is to allow nominal exchange rates to move around. for decades, canada has benefited from having a flexible exchange rate that can help bring about economic adjustments. by the end of the 1990s, most industrialized economies and a number of emerging - market economies had also realized the benefits of having a floating currency. but other economies, particularly but not exclusively here in asia, have opted for a fixed exchange rate regime. and unfortunately, some have rejected the adjustment mechanisms that should go along with such a regime. by sterilizing their interventions, they are accum