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COSTS AND BENEFITS OF EXCHANGE RATE STABILITY:
CANADA'S INTERWAR EXPERIENCE
MICHAEL D. BORDO and ANGELA REDISH*

In January 1929, the Canadian government suspended gold
exports and implemented a floating exchange rate regime that
endured until the onset of World War II. In sharp contrast to
the experience of other countries that left the gold standard,
Canada's deflation and declining economic activity continued
until 1933. This paper examines why the Canadian government
chose to follow a restrictive monetary policy and how that
policy affected the Canadian exchange rate. We show that the
chosen policy was rational—given the government's assumptions
and objectives—and that it was consistent with fiscal policy. In
so doing, we argue that the government's commitment to monetary
stability was credible. We show that one can explain the
Canadian exchange rate's behavior by a simple expectationsbased model of exchange rate determination, given external
events and the government's monetary policy.
I.

INTRODUCTION

The experience of the Canadian economy during the Great
Depression was unique in several ways. Like many small open
economies, Canada abandoned the gold standard at the onset of the
Depression. But unlike most of these (e.g., Argentina and Australia),
Canada allowed neither the exchange rate to depreciate nor prices
to rise. Canada allowed concern for its standing among international
creditors to dominate domestic economic concerns. Other nations
gave domestic economic concerns precedence over depreciation and
permitted a partial default on foreign liabilities (Eichengreen and
Portes, 1987). The Canadian government adopted a restrictive monetary
policy, acting as if it were still bound by gold standard rules.
This paper examines both why the Canadian government chose to
follow a restrictive monetary policy and how that policy affected
the Canadian exchange rate. We show that, given the government's
*Visiting Professor, GSIA, Carnegie-Mellon University, Pittsburgh, Pa., and Assistant
Professor, Department of Economics, University of British Columbia, Vancouver, respectively.
The authors thank Shirley Haun for research assistance, the Bank of Nova Scotia Archives
for access to its material and, especially, Ronald A. Shearer both for donating his data
and for his comments. An earlier version of this paper was presented at the 62nd Annual
Western Economic Association International Conference, Vancouver, B.C., July 1987, in a
session organized by Michael Bordo. The authors thank Barry Eichengreen, Peter Howitt,
David Laidler, Anna Schwartz, and Peter Temin for helpful comments on an earlier draft.
The usual disclaimer applies.

Contemporary Policy Issues
Vol. VI, April 1988



115

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CONTEMPORARY POLICY ISSUES

assumptions and objectives, the chosen policy was both rational and
consistent with fiscal policy. Thus, we argue that the government's
commitment to monetary stability was credible. We also show that,
given external events and the government's monetary policy, one can
explain the Canadian exchange rate's behavior by a simple expectations-based model of exchange rate determination.
In the remainder of this section, we describe more carefully the
Canadian exchange rate's actual behavior. In section II, we describe
the Canadian financial system as it existed during the late 1920s
and the 1930s. Then, in section III, we examine the costs and benefits
of the government's commitment to monetary stability. Section IV
incorporates our analysis of government behavior into an explanation
of the Canadian dollar's behavior. The concluding section summarizes
our results and suggests implications for contemporary economic
policy.
Figures 1 and 2 show the behavior of the Canadian dollar. Figure
1 shows the behavior of the Canadian dollar-British pound exchange
rate and the Canadian dollar-U.S. dollar exchange rate. All three
countries were on the gold standard in 1928, when the exchange
rates were C$4.86=£l and C$1=U.S.$1. The figure shows that between
January 1929—when Canada suspended the gold standard (see section
II)—and September 1931, the Canadian dollar remained at or very
near the gold standard parity. In September 1931, Britain abandoned
the gold standard. Figure 2 shows that the pound depreciated by
about 30 percent with respect to the U.S. dollar and that gold—that
is, the price of an ounce of gold—rose from approximately £4.25
to £5.50. The Canadian dollar price of gold also rose but by less,
reflecting a depreciating Canadian dollar with respect to the U.S.
dollar and an appreciating Canadian dollar with respect to the pound.
In March 1933, the U.S. also abandoned its traditional parity of
$20.67 per ounce of gold. The price of gold then rose gradually
from $20.67 to $35.00 between March 1933 and January 1934. Figures
1 and 2 show that after 1934, all three currencies had depreciated
against gold to about the same extent. Thus, the Canadian exchange
rate, with respect to both currencies, had returned to approximately
the gold standard parity.
Our analysis of exchange rate behavior focuses particularly on
why the Canadian dollar did not depreciate before October 1931
and why the Canadian dollar appreciated with respect to sterling
between October 1931 and March 1933. We suggest that the answers
lie with the macroeconomic policies that the government pursued
over the period.




BORDO and REDISH: CANADA'S EXCHANGE RATE STABILITY

FIGURE 1
Exchange Rates, Canada/USA, Canada/UK, 1928 = 100
Monthly, Seasonally Adjusted




FIGURE 2
Price of Gold, 1928 = 100
Monthly

117

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CONTEMPORARY POLICY ISSUES
II.

CANADIAN FINANCIAL INSTITUTIONS

Canada returned to the gold standard in 1926 following a 12-year
suspension that began with the onset of World War I. The circulating
money stock at that time was composed of gold and subsidiary coin
in the hands of the public, government-issued Dominion notes in the
hands of the public, and commercial bank-issued notes and deposits.
Dominion notes were Canadian government-issued notes that were
convertible on demand into gold coin. They were issued under two
pieces of legislation: the Dominion Notes Act and the Finance Act.
The Dominion Notes Act permitted the government to issue $63.5
million notes with a 25 percent gold reserve, with all notes exceeding
$63.5 million backed 100 percent by gold. Legislation of this type
was first passed in 1870 and had since been amended to raise the
limit from $9 million to $63.5 million. The second authority for
note issue—the Finance Act—permitted the government to lend
Dominion notes, with no reserve requirements, to chartered banks
pledging appropriate collateral. These loans were made at the Finance
Act discount rate. The Dominion Notes Act of 1870 also granted
the government a monopoly on issuing notes less than $5 in value.
By the 1920s, the Dominion notes outstanding were mostly small
notes in the hands of the public and large-denomination ($50,000)
notes that the banks used as reserves.
The banking system comprised 10 chartered banks, each with many
branches. The banks issued notes and held demand deposits and time
deposits. The banks' liabilities were not subject to reserve requirements, though banks had to hold 40 percent of their reserves in the
form of Dominion notes. Bank liabilities were not legal tender. If
a bank could not redeem its demand deposits and notes on demand
in gold or Dominion notes, it risked losing its charter.
Because of the highly concentrated nature of the banking
system—the three largest banks held 75 percent of the system's
assets—close cooperation among individual banks was possible. This
was facilitated by the Canadian Bankers' Association (CBA), an
organization involved primarily in educating bank officers. The CBA
also ran the clearinghouse and, by an amendment to the Bank Act
in 1901, the government recognized the CBA as "an agency for the
supervision and control of certain activities of the banks" (Watts,
1972, p. 18).
In late 1928, the government failed to raise the Finance Act
discount rate to a level comparable with that of the New York
market. This led to a dramatic decline in the government's gold
reserves. The banks borrowed Dominion notes from the Finance
Department, made the government convert them into gold, and then




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119

exported the gold to invest in the New York market. The government's
declining reserves forced it to react, and the Minister of Finance
used moral suasion to stop the Canadian banks from exporting gold.
From early 1929 until the formal embargo on gold exports on October
19, 1931, gold exports were halted by this informal arrangement.
Frank Knox (1939, p. 20), the leading historian of this period's
policy, noted that "the price of foreign exchange was free to vary
according to conditions in a free market."
Suspension of the gold standard, both before and after 1931, was
an awkward arrangement. Banks were required to convert their
liabilities into Dominion notes at all times. Convertibility of Dominion
notes into gold was not suspended until 1933. However, the
government argued that because gold coin could be neither exported
nor melted down, individuals would be no better off if they received
gold than if they received Dominion notes. And the government, in
fact, refused to redeem Dominion notes in gold.
In this paper, we argue that the government's credible commitment
to a stable monetary policy was the critical determinant of the
Canadian exchange rate during the 1930s. Canada's unique financial
institutions suggest two alternative hypotheses: (1) that the banking
sector's oligopolistic nature had a significant impact on the stock
of money, or (2) that the absence of a central bank impeded the
practice of monetary policy.
First, the Canadian banks were a tightly knit group and could
have operated as a collusive monopoly. Had the government been
willing to lend reserves under the Finance Act at a fixed nominal
discount rate, the banks could have increased their liabilities. The
theory of a seignorage-maximizing money issuer suggests that the
banks would have been able to profit greatly from inflation (Bailey,
1956, pp. 93-110). This theory assumes, however, that the inflation
would have been permanent. We argue that the banks, as well as
the nonbank public, believed that the government was committed to
exchange rate stability. Therefore, the banks expected that eventually
they would have to return the stock of their liabilities to its
pre-suspension value. This could be done only by redeeming the
liabilities in gold before returning to the gold standard. The banks'
inflationary policies would have raised the value of gold, however,
and the required gold purchases would have eliminated most of the
potential seignorage gain. Thus, given their expectations of government
policy, the banks had little incentive to generate an inflationary
monetary expansion.
The banks' potential profit clearly depended on the discount rate's
remaining fixed. The government's refusal to raise the discount rate
in 1928 and in early 1929 raises this possibility, but the Department




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CONTEMPORARY POLICY ISSUES

of Finance's stance apparently had changed by mid-1929. A letter
from the Minister of Finance to the CBA President in August 1929
contained a copy of a memo—prepared by the Department of the
Finance for the House of Commons—stating that the Department was
willing to control the banks by changing the discount rate:
If the Treasury should at any time feel convinced that Dominion notes
issued to banks against securities are being used other than for the purpose for which they are issued, the rate of interest charged the banks
for such issues will be raised to a rate which will prohibit such misuse
(Archives of the Bank of Nova Scotia No. 69-52, Sec. 1, File 84 "Gold"
Memorandum on Exchange and Gold Reserves and Operations of the
Finance Act, 1914).

The second alternative explanation for the Canadian exchange
rate's surprising behavior during the 1930s is the absence of a central
bank. One could argue that Canada lacked the institutions to affect
a depreciation of the exchange rate. Two arguments oppose this
hypothesis. Although no central bank existed in Canada, the main
functions of a central bank were provided by alternative institutions.
For example, the CBA operated a clearinghouse and the Department
of Finance operated a discount window. Lack of a central bank
would not have prevented the government from altering the discount
rate or "printing money."
Comparing the exchange rate's behavior before and after the Bank
of Canada began operations in 1935 provides more compelling
evidence that lack of a central bank was not the critical determinant
of such behavior. Elsewhere, we have estimated univariate and
bivariate models of the Canadian exchange rate, money stock, and
price level (Bordo and Redish, 1987a, pp. 405-418) and found that
"the introduction of the Bank of Canada did not alter the money
supply process in Canada, and did not affect the evolution of the
key nominal variables in the economy" (p. 414). In that paper, we
argue that the Bank of Canada was instituted in a response to
political repercussions of the Great Depression, and that the Bank
concerned itself with no macroeconomic policy other than debt
management during the 1930s.
Canadian financial institutions were unusual—i.e., no central bank
and an oligopolistic chartered bank system—yet the evidence suggests
that these characteristics were not the determining factor in the
behavior of the exchange rate.
III. THE GOVERNMENT'S POLICY DECISION

In early 1930, the government vowed to maintain the exchange
rate at its traditional parity and not to expand the money stock by




BORDO and REDISH: CANADA'S EXCHANGE RATE STABILITY

121

either issuing unbacked Dominion notes or reducing the gold backing
of the notes. The government gave three reasons for this policy:
(1) The potential benefits of depreciation/monetary expansion, in
terms of reduced unemployment, were uncertain (see House of
Commons, Debates, 3rd session, 17th Parliament, p. 650).
(2) A depreciation would increase costs of servicing the foreign
currency-denominated debt (see House of Commons, Debates, 1st
session, 17th Parliament, p. 78).
(3) Monetary expansion would cause a flight from the dollar (see House
of Commons, Debates, 4th session, 17th Parliament, p. 3208).
Responding to frequent questions from members of the radical
United Farmworkers of Alberta, the government reiterated its policy
in the House of Commons. This was widely reported in the newspapers,
so that the government's views were well known. Whether the
government's policy commitment was credible, however, depended
on (1) whether the public perceived the policy as reflecting the
government's self-interest and (2) the extent to which it was compatible with other government policies. As table 1 shows, the
government ran a budget surplus until 1931 and then ran a deficit.
The calculations have not been performed for Canada, but it seems
likely that the Canadian government—like the U.S. government
(Brown, 1956, pp. 857-879)—ran a budget surplus on a full-employment basis throughout the Depression years. Thus, the government's
fiscal policy was consistent with a tight monetary policy.
We examine each of the government's arguments against monetary
expansion/depreciation below.
A. Depreciation and Economic Recovery

Considerable evidence now exists that countries that depreciated
their exchange rates early in the 1930s enjoyed a more rapid
economic recovery than did those that maintained fixed exchange
rates (see Eichengreen and Sachs, 1986, pp. 925-946). In 1931,
however, the Leader of the Opposition, W. L. McKenzie King,
reflected popular opinion:
This is a matter which is giving rise to a great deal of study on the
part of the most thoughtful economists and the most earnest of social
reformers and workers, and there is at the present time no general consensus of view which one can say is accepted (House of Commons,
Debates, 2nd session, 17th Parliament, p. 2669).




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CONTEMPORARY POLICY ISSUES

TABLE 1
Government Expenditures and Revenues
]1928/1929

Expenditures
Interest
124.989
225.963
Ordinary
Special
5.998
Total
356.950
Revenues
Import Duties 187.206
Excise Duties 63.684
83.007
Sales Tax
Income Tax
59.422
Other Ordinary 62.144
Other Special
5.476
Total
460.940
Balance
103.990

1929/1930 1930/1931 1931/1932 1932/1933
121.566
236.213
13.570
371.349

121.289
268.269
17.831
407.389

121.151
254.252
55.959
431.362

134.999
223.529
96.892
455.420

179.429
65.035
63.409
69.020
64.518
4.540
445.952
74.601

131.208
57.746
34.734
71.048
54.851
6.622
356.210
(51.179)

104.132
48.654
59.606
61.254
56.063
7.028
336.737
(94.625)

70.072
37.833
82.191
62.066
54.474
4.492
311.129
(144.291)

Source: Canada, Public Accounts, various years.

B. Depreciation and the Government's Financial Status

Analyzing the effect of depreciation/inflation on the government's
income, expenditures, and balance sheet is critical to assessing the
benefits of monetary expansion/depreciation. To evaluate the effects
completely would necessitate a model of the entire macroeconomy
since, for example, tariff revenues depended on import levels and
income taxes depended on income levels. At that time, the effects
of depreciation on income levels were considered indeterminate so
that contemporaries were uncertain as to the scale of these effects.
(It is contemporaries' expectations of changes in government revenues
that we examine here.)
Thus, we analyze the effect of depreciation/monetary expansion
on the government's liabilities. Tables 2 and 3 show the extent of
these liabilities and related interest obligations, while table 1 shows
the impact of interest-bearing debt on total government expenditures.
The tables illustrate that the Canadian government had a large
outstanding debt and that the interest payments were about one-third
of government expenditures.
To examine the potential impact of depreciation/monetary expansion
on the government's balance sheet, we analyze the effects of two
Counterfactual policies. The first is a 15 percent increase in the stock
of high-powered money in September 1930. We chose this date




BORDO and REDISH: CANADA'S EXCHANGE RATE STABILITY

123

TABLE 2
Funded Debt and Monetary Issues of the Dominion Government a
Outstanding
September 30, 1930
(C$m)

Outstanding
March 30, 1932
(C$m)

311.68
165.90

311.68
240.97

1,444.12
362.00
2,283.75

790.31
1,221.31
2,564.28

169.57

157.34

In sterling (Bf)
In U.S. funds (Bf)
In Canadian funds
Gold bonds (Bdg)
Other (Bdc)
Total
Dominion notes outstanding (H)
a

Data on funded debt include only direct liabilities and not indirect liabilities—
that is, guaranteed debt issued by railroads. Debt includes matured but outstanding
amounts and is gross of deductions for sinking funds. (Sinking funds were held only
against foreign currency-denominated debt.)
Source: Canada, Public Accounts, 1930/1931 and 1931/1932; Moody's Manual of
Investments, Government Securities, 1930, 1932.

TABLE 3
Interest and Maturing Debt Obligations
September 1930September 1931
(C$m)
Interest obligations
London
New York
Canada—Gold
Canada—Nongold
Canadian Gold/New York
Miscellaneous
Total Interest Obligations
Maturing Debt
Canada—Gold
New York
Grand Total




March 1932March 1933
(C$m)

11.14
10.09
79.90
16.71

11.14
11.96
36.67
61.49
6.15
1.67
129.09

1.67
117.85
52.93
25.00
195.78

34.45
163.54

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CONTEMPORARY POLICY ISSUES

because it coincides with the election of the Conservative Bennett
government and with calls for a monetary expansion by some Members
of Parliament. A 15 percent expansion is considered because the
exchange rate actually depreciated by about 15 percent approximately
one year later. The second situation we analyze is a 15 percent
monetary expansion in March 1932. This date was chosen because
the Prime Minister at that time seriously considered a memo
recommending depreciation and monetary expansion. (The memo was
given to him by the Inspector General of Banks and authored by
the future first Governor of the Bank of Canada.) A 15 percent
depreciation would have put the Canadian dollar at approximately
the traditional parity with sterling, or £1=$4.86.
Assume that a monetary expansion would lead to a proportionate
depreciation of the exchange rate and inflation of the domestic
price level. The policy's effect on the government's balance sheet
would depend on the nature of government liabilities. The real
value of Dominion notes would decline by the amount of the
inflation, and the real value of government bonds payable in
Canadian dollars would fall equally. Canadian bonds payable either
in foreign currencies or in gold would not decline in real value.
Depreciation would reduce the real value of the liabilities to an
extent dependent on their composition.
If we relax the assumption that the exchange rate and price level
increase proportionately with the monetary expansion, the direction
of effect becomes ambiguous. (Bordo and Redish, (1987b) analyze
these relationships more fully.) Consider the case in which the exchange rate depreciates but prices do not increase at all in the short
run. The net gain from monetary expansion is the dollar amount of
the expansion less the increase in the real value of bonds denominated
in foreign currency. Because the government clearly felt that this
latter case was the most relevant one, we assume those conditions
in the Counterfactual analyses.
Before we undertake the analysis, we must clarify two empirical
details. The government's attitude toward its gold bonds was an important determinant of the potential benefits of monetary
expansion/depreciation. Gold bonds were those denominated in
Canadian dollars and payable in gold. If the government honored
the gold clause, a depreciation causing the price of gold to rise in
Canadian dollars would increase the real value of gold bond liabilities.
As table 2 shows, gold bonds constituted 63 percent of the government's funded debt in September 1930. After the depreciation in late
1931, however, the government refused to pay in gold to Canadian
residents holding gold bonds. Instead, the government offered




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125

Canadian legal tender—that is, Dominion notes. Foreign residents
holding the same bonds were paid in gold.
The Counterfactual analysis requires assumptions about the
government's behavior toward foreign and domestic gold bondholders
and about the proportion of each to the total. We assume that the
government would have behaved toward gold bondholders as it
actually did, and that nonresidents held 50 percent of the gold bonds.
The Counterfactual analysis is complicated further by the conversion
loan of 1931. Most gold bonds outstanding in 1931 were due during
the mid-1930s and originally had been issued to finance World War I.
To take advantage of the low interest rates in 1931, the government
undertook a massive refinancing whereby individuals would convert
their old bonds to new bonds with a 20-year term. The gold clause
was removed or forgotten during this process. A possible—and, at
first glance, very plausible—explanation of this omission is that the
government foresaw the possibility of depreciation and wanted to
maximize the benefits from such a policy. The subsequent decline
in the value of the Canadian dollar lends considerable credence to
this interpretation. If this were the case, then the Counterfactual
analyses become more complex. They must examine whether the
government would have undertaken the conversion loan in early 1930
had it been considering depreciating later that year, and whether the
conversion loan would have occurred in 1931 had the currency
depreciated in 1930. Fortunately, a detailed investigation of the
evidence suggests that the government was not acting strategically.
The first piece of evidence is that Canadians held most of the
debt and that, as noted above, the Canadian government did not
honor the gold clause on bonds held by Canadian residents. This
reduced considerably the payoff to removing the clause. Further, the
government was worried about its international reputation and so
may well have determined that the cash savings on the foreign-held
bonds was less than the cost of losing its reputation. Second,
Department of Finance records concerning the conversion loan contain
virtually no discussion of the change from gold bonds to non-gold
bonds, suggesting that the change was not considered significant.
1. No systematic data exist on the residence of the bondholders, but qualitative evidence
suggests that 50 percent is an overestimate of foreign holdings.
2. Clearly, one could make the more sophisticated argument that the bond purchasers/converters recognized the change in the bonds' status and calculated the interest rate required
to compensate them for the change in status. This calculation would have been based on
(1) expectations of depreciation conditional on the changed incentives for the government
to depreciate, and (2) expectations of the probability that the government would honor the
gold clause. Again, the Department of Finance records containing correspondence concerning the Conversion Loan, minutes of meetings of the Loan Committee, and intradepartmental
memos suggest that the government was not thinking in these terms.




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CONTEMPORARY POLICY ISSUES

We now analyze the two Counterfactual policies: a 15 percent
monetary expansion in September 1930 and a 15 percent monetary
expansion in March 1932. In both cases, we make the extreme
assumptions that the monetary expansion causes an immediate and
proportionate depreciation of the exchange rate and that the domestic
price level does not change. We choose these assumptions to reflect
the government's priors.
In September 1930, a 15 percent monetary expansion would have
yielded $25.4 million in direct seignorage revenue. If half the gold
bonds were paid in gold and all the foreign currency debts were
honored, the increased liability would be $179.95 million. If none
of the gold bonds was redeemed in gold, the real value of liabilities
would rise by only $71.64 million. In either case, the net effect on
the government's balance sheet is negative. This accounting measures
the permanent effect, however, while the government apparently was
more concerned with short-run costs. We examine the policy's potential
effect on the value of maturing debt and interest due during the
next 12 months. If 50 percent of debts due in gold were paid in
gold and if foreign currency debts were paid in those currencies,
the increased costs would be about $17 million (interest owing in
non-Canadian currency—$62.85 million; principal owing in
non-Canadian currency—$51.46 million; 15 percent of $114.31
million). If none of the gold debt were paid in gold, the cost would
decrease to $7.2 million ($47.9 million x 15 percent). Even using
a one-year time horizon, the seignorage revenue would be offset
considerably by the increased costs of foreign payments. Using the
scenario most favorable to the government—no nonresident gold
bondholders—the 15 percent expansion/depreciation would increase
net revenue by $18.2 million ($25.4-$7.2 million). That would
represent 6 percent of total tax revenue for the year.
The second experiment is a 15 percent monetary expansion in
March 1932. We undertake the same calculations. The monetary
expansion would raise $23.6 million of seignorage revenue. If half
the gold bonds were redeemed in gold, the permanent increase in
the value of outstanding debt would be $142.17 million. If none of
the gold bonds was paid in gold, the real value of the liabilities
would rise by only $82.9 million. If, on the other hand, we evaluate
the impact on cash outlays during only the next 12 months, then
these rise by $9.97 million in the first case and by $15.31 million
in the second case. Again, the increase in the liabilities offsets
considerably the gain of seignorage revenue.
In both cases, the monetary expansion generates net revenue for
the government in the short run (12 months)—even under our strict
assumption that domestic inflation does not occur and so does not




BORDO and REDISH: CANADA'S EXCHANGE RATE STABILITY

127

improve the government's fiscal position by reducing the real value
of Canadian dollar-denominated bonds. In either case, however, the
benefits are not large.
C. Depreciation, Capital Flight, and Reputation Effects

The final factor entering into the government's decision was the
effect of depreciation on holders of Canadian liabilities. The
government feared a capital flight—a speculative outflow of foreign
capital. We may distinguish a permanent flight of capital from a
temporary flight of capital. A temporary flight of capital involves
an outflow of capital occurring when a currency depreciation is
anticipated. Once the depreciation has occurred, the capital will
return if currency stability is foreseen. A permanent flight of capital
occurs if the depreciation or other event leads investors to revise
permanently the risk premium associated with investment in a
particular country.
In September 1931, the government's rhetoric aimed at preventing
a short-run flight of capital by investors who might expect the
Canadian dollar to depreciate with the pound sterling. From early
1929 on, however, the government also was concerned over averting
a permanent flight of capital by investors who might expect Canadian
securities to become riskier. The costs of such a flight from capital
would depend on the nature of the capital market. They would be
reflected in higher interest costs imposed by a higher risk premium
or in a sharp decrease in the availability of funds if capital markets
were imperfect and lenders were rationed.
The government's strategy, which relied on a degree of market
segmentation, was to maximize its revenue while not offending foreign
lenders. That is, the government treated Canadians and foreigners
differently. The government assumed that had some market power in
the Canadian loan market but none in the international capital market.
This implied that the cost of defaulting to Canadian bondholders
was less than the cost of defaulting to foreigners. Thus, non-Canadian
holders of gold bonds were paid in gold. The Canadian strategy
imposed some capital losses on foreign residents holding nongold
Canadian dollar-denominated bonds, but these were minimal.
IV.

EXPECTATIONS AND THE EXCHANGE RATE

We have argued that the government opted not to undertake an
inflationary monetary expansion because it felt that the cost of losing
its reputation as a sound debtor exceeded the potential benefits.
Because the public gave credibility to the government's stated policy,
the policy had an important impact on exchange rate expectations.




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CONTEMPORARY POLICY ISSUES

In the long run, the exchange rate is determined by the relative
excess supplies of the two monies. However, foreign exchange is a
financial asset whose price is determined in an asset market where
expectations are critical. Therefore, changing expectations of future
monetary policy are an important determinant of daily changes in
the exchange rate.
The actual behavior of the exchange rate during the 1930s was
described in the Introduction. In this section, we explain such behavior
as resulting from changing expectations. These expectations were
conditioned on the Canadian government's behavior and on foreign
events presumably exogenous to the Canadian economy.
We divide the period into four subperiods: January 1929-September
1931, October 1931-March 1933, April 1933-December 1933, and
January 1934 on. During the first period, the currencies of Canada's
major trading partners and sources of capital—the U.S. and the
United Kingdom—remained tied to the gold standard while the
government repeatedly stated its "sound money" policy. Because of
the government's credible commitment, the public had no reason to
anticipate a depreciation and the exchange rate remained in equilibrium
at the traditional parity of C$1=U.S.$1 and C$4.86=£l.
In September 1931, the pound sterling left the gold standard and
depreciated against the U.S. dollar by about 30 percent. The Canadian
exchange rate no longer could remain at the traditional parity with
both the U.S. dollar and the pound sterling. The government continued
to stress the sound money policy. We suggest that agents decided
to hedge their bets—by assigning the probability
to resuming the
fixed exchange rate at the traditional parity with the U.S. dollar and
the probability (1 - ) to resuming the traditional parity with sterling.
The path of the exchange rate is consistent with this hypothesis (see
figure 1) and suggests that the value of
was approximately 0.5.3
The U.S. left the gold standard in March 1933. By January 1934,
the price of gold had risen from $20.67 to $35.00 an ounce. During
this intermediate period, associated with great uncertainty in all three
countries, the Canadian exchange rate again stayed between those
of the pound and the U.S. dollar.
The U.S. fixed the price of gold at $35 an ounce in 1934, while
the U.K. allowed the pound to depreciate so as to reestablish the
traditional parity of £1=U.S.$4.86. This, of course, allowed the
Canadian dollar to return to the traditional parity with both currencies.
We argue that agents expected such a parity to be reestablished.

3. In Bordo and Redish (1987b), we report the results of an econometric estimate for
. We conclude that =0.55 before February 1934 and that =0.77 after that date.




BORDO and REDISH: CANADA'S EXCHANGE RATE STABILITY

129

From 1934 until the onset of World War II, the Canadian exchange
rate stayed at or near those parities.
V.

CONCLUSIONS AND POLICY IMPLICATIONS

Canada left the gold standard de facto in early 1929, but the
Canadian dollar did not depreciate vis a vis the U.S. dollar until
Great Britain left the gold standard in September 1931. Even then,
the Canadian dollar fell only half as much as did sterling until
traditional parities were reestablished in 1934. We argue that Canada
failed to increase the money stock, depreciate the currency, and
enjoy the potential benefits realized by other countries pursuing such
policies because the government was reluctant to depart from a policy
consistent with a strict interpretation of gold standard rules. The
government was reluctant to conduct an expansionary policy because
it believed the latter's potential benefits—reduced unemployment,
rising economic activity, increased tax revenue, increased seignorage,
and reduced real value of its domestic obligations—were outweighed
by the costs of increased interest payments on its outstanding
foreign-held gold and other currency-denominated debt and by the
costs of losing its reputation for sound money.
The public, including the banks, understood and believed the
government's commitment to sound money and to a fiscal policy
consistent with such a position. Hence, expectations of returning to
the gold standard dominated exchange rate determination until
September 1931. After that date, until the U.S. declared a higher
U.S. dollar price for gold, the Canadian exchange rate was influenced
strongly by the probabilities that the public attached to Canada's
following the policy of its two principal trading partners.
The Canadian experience of the 1930s has important policy implications for the present. First, Canada clearly is a country that
followed a consistent monetary and fiscal policy and made a credible
commitment to sound money and exchange rate stability during the
1930s. Canada's 1930s experience has present-day relevance for
countries such as Argentina and Brazil, which have been unwilling
to follow such policies.
Second, Canada's willingness to honor its externally held debt
also has relevance for today's less-developed country (LDC) debtors'
threatening not to do so. Canada benefitted from its 1930s policy
in that it was the last country to receive foreign loans before they
dried up in 1932.
Third, Canada's sound money policy may seem well conceived in
terms of present conditions but may not have been optimal at that
time. The experiences of Great Britain, Sweden, Australia, and other




130

CONTEMPORARY POLICY ISSUES

countries suggest that depreciation might have cut short the Great
Depression's effect on Canada. (Canada's proximity to the U.S.,
however, likely would have tempered any expansion that might have
resulted from depreciation.) These experiences suggest that interpreting
the gold standard rules as being contingent on relaxing the gold
basis during national emergencies, such as wars or depressions, may
have been correct.
REFERENCES
Bailey, M. J., "The Welfare Cost of Inflationary Finance," Journal of Political Economy, 44,
1956, 93-110.
Bordo, M. D., and A. Redish, "Why Did the Bank of Canada Emerge in 1935?" Journal of
Economic History, June 1987a, 405-418.
, "Credible Commitment and Exchange Rate Stability: Canada's
Experience," NBER Working Paper No. 2431, 1987b.

Interwar

Brown, E. C , "Fiscal Policy in the "Thirties: A Reappraisal," American Economic Review,
1956, 857-879.
Eichengreen, B., and R. Portes, "The Anatomy of a Financial Crisis," NBER Working Paper
No. 2126, 1987.
Eichengreen, B., and J. Sachs, "Exchange Rates and Economic Recovery in the 1930s,"
Journal of Economic History, 1986, 925-946.
Knox, F., Dominion Monetary Policy, Ottawa, 1939.
Watts, G., "The Origins and Background of Central Banking in Canada," Bank of Canada
Review, 1972, 14-27.