MONETARY POLICY, CURRENCY SUBSTITUTION AND THE TRANSMISSION OF SHOCKS FROM THE US TO CANADA; 1976-1984: A RATIONAL EXPECTATIONS APPROACH (UNITED STATES)

This thesis estimates and simulates a structural rational expectations model of Canada over the period from 1976-1984. The model features a staggered wage setting process which allows monetary policy to be effective in stabilizing output in a rational expectations framework.; A major purpose of this research is to examine the implications of the empirical finding that Canadian money demand is significantly affected by the expected return on US dollar denominated money balances, that is, by the expected change in the exchange rate. The idea that since Canadians hold significant quantities of US{dollar} denominated non-interest bearing monetary assets, Canadian money demand should be a function of the expected change in the exchange rate is the foundation of the currency substitution literature. Contrary to the currency substitution literature which argues that currency substitution results in increased exchange rate volatility, simulations in this dissertation demonstrate that the impact of currency substitution, in a sticky price framework, is to diminish exchange rate overshooting and therefore the volatility of the Canadian dollar.; Another purpose of this thesis is to examine the ability of Canadian monetary policy to offset shocks from the US by simulating US interest rate and output shocks with different Canadian monetary policies. The tradeoffs involved in offsetting shocks are assessed by examining the deviations of the price and output levels from their initial steady states. The results of this analysis are that policies of accomodating price shocks are inefficient and policies which offset price and output shocks have roughly constant price output volatility tradeoffs.; Finally, further evidence is offered concerning the existence of the currency substitution effect. This section uses two-step, instrumental variables, and joint estimation techniques and finds some additional evidence for the existence of this effect. This result is interesting since interest rate differentials or equivalently, the forward premium, have been used exclusively in the literature to proxy the expected change in the exchange rate.