The desirability of different exchange rate systems for NAFTA
July 24, 2019
There are currently several different possibilities which researchers have discussed including those based on optimal currency theory. They include a rapid shift to monetary union; a fixed but adjustable exchange rates among the Canadian dollar, the US dollar and the Mexican peso (a system like the European Rate Mechanism); or continuing the floating exchange rates among the NAFTA currencies.
Prepare the key arguments – if you were a Canadian (or a Mexican, or an American) politician or businessperson, what system would you favor? Analyze and discuss.
Franziska Rudolph 283296
Berlin, den 16.02.2011
The North American Free Trade Agreement program of liberalization of the North American trade has notably increased trade and investment in North America. NAFTA improved the competitiveness of companies, removed trade barriers, promoted the flow of cross-border goods and services, and facilitated the movement of capital. As a result, the size of the North American economy has grown more than twice as much from U.S. $ 7.6 trillion in 1993 to U.S. $ 16 trillion in 2007. There is no doubt that NAFTA has stimulated trade and investment, secured jobs, increased economic growth and managed goods and service flow between the three partner countries Canada, the United States and Mexico.  From a Canadian point of view, companies can establish a strong market position in North America to then serve markets gloablly.  Hence, Canada drew the most out of the NAFTA. With a GDP rate at 3.6%, it enlarges faster than the United States with 3.3% and Mexico with only 2.7%.  As indicated in table 1, the intra-regional trade agreement (RTA) exports have augmented considerably from 1990 to 2004 as an answer to the US-Canadian Free Trade Agreement CUFTA and NAFTA. The introduction of the CUFTA in 1989 and NAFTA in 1994 had reinforced the direction of closer economic relations in North America. 
Table 1: Total and intra-EU and NAFTA exports
Capital moves freely among the United States and Canada and relatively freely with Mexico, but unfortunately the work force does not. Structural similarities between the markets of Canada and the United States are sizeable, but not with Mexico either. Also, there is little, if any, coordination of fiscal, monetary or other policies between the three countries.  Therefore, NAFTA is only a (nearly) free trade area.  The debates on an optimal currency area of NAFTA are therefore clearly vitiated. The theory of optimal currency areas was developed mainly by Robert Mundell in the 1960s. An optimal currency area refers to a group of nations that would benefit from a fixed and rigid definition of the exchange rate of its currency and a possible eventually common currency. 
NAFTA’s and Canada’s current exchange rate is a floating system. But the floating exchange rate is not in the economic interest of Canada. Floating rates lead to volatile real exchange rates and they do not seem to effective buffer against external shocks. They can also lead to longer currency misalignment, as demonstrated by the current period of pronounced weakness against the U.S. dollar. This weakness and volatility tend to dampen the productivity improvements of Canadian businesses that export or compete with imports. Also the development of human-capital-intensive industries in Canada may be discouraged due to bad investment choices in the direction U.S. locations and consequently away from Canadian ones.
With regard to the Canadian economy becoming increasingly open to trade and investment markets, and because they are more and more concentrated on the United States, the benefits of greater exchange rate fixity with the U.S. dollar are rising.  Such a system would support wage and price flexibility in Canada while promoting businesses and workers to be more aware of their company’s competitive position in North America. The prices for Canadian financial and real assets would stabilize and currency exchanges and other transaction costs for cross-border trade and investment would be reduced.  But here, the economists of the Bank of Canada have compellingly quarreled that this is “not in the best economic interest of the nation.” They stressed “that since the changes in the U.S. dollar / Canadian dollar exchange rate were primarily driven by asymmetric commodity price shocks, a fixed exchange rate would robbed Canada an important adjustment mechanism.” 
Certainly, at an elemental point of view, a system of flexible exchange rates is an essential requirement for economic integration. But on the other hand it was during the fixed rate period of the 1960s that Canada developed its ample social policy infrastructure.  The paybacks of exchange rate fixity rise with the extent of international openness in particular when this openness includes such a high degree of export integration with an economic and currency superpower. Fixed exchange rates give Canada a greater possibility of getting their share of North American investment based on the competitive advantage of its industries and firms.  On the fiscal side and in the framework of already high and increasing trade integration a fixed rate could formulate one of the most steady and viable of such schemes. While regarding a fixed rate system as a reasonable option for Canada, the monetary authorities must first show their readiness to utilize monetary policy to carry on exchange rate goals in the form of a target band for the exchange rate, rather than just interfere in the foreign exchange rate market. Concisely, credibility has to be earned and, thus, it would be foolish to progress rapidly to a fixed exchange rate. 
The last option economists see, is a monetary union. Monetary Unions are clusters of countries which share a currency. Generally, they allocate geographical borders. Moreover they commonly have close trade and other financial affairs.  Though the NAFTA member countries do the above named, a monetary union for NAFTA is not realistic for two reasons. The first reason concerns the great implausibility of moving from the lowest level of integration to the highest in a leap. Although the NAFTA member governments have settled fairly easy on trade and investment matters, there has still no North American economy or community emerged. And secondly, there is an institutional incompatibility present “between the mandates of the Canadian and the U.S. central banks. The U.S. Federal Reserve does not represent the public interest. The twelve districts of the Reserve are in the control of commercial banks. The Bank of Canada is like the European Central Bank (ECB), a public institution.” It is consequently not feasible to apply the ECB model on a potential North American central bank.  Also there is only a small or even “no chance that NAFTA could lead to this type of monetary integration in North America anytime soon.” The United States would not agree to a common central bank and a common currency. They would not even agree if the common currency were the U.S. dollar. Above and beyond it would not be possible. “The Constitution of the United States (Article I, Section 8) assigns the power to coin money and to regulate the value of money to the U.S. Congress” only. Thus it would be unconstitutional for other nations to have the power to issue dollars and regulate its value with the U.S. Congress. 
Monetary integration in North America then could take the more feeble form of unilateral dollarization (concerning Canada and Mexico). The positive paybacks that Canada would get from dollarizing are for example the prevention of the cost of exchanging the domestic currency for dollars. Dollarization could as well reduce or eliminate the requirement for foreign exchange and trade controls. It could promote budgetary discipline, and encourage more rapid or even full international financial integration. In contrast dollarization, however, would impress the following costs on Canada. They would lose self-government of monetary and exchange rate policies and would have to face the monetary policy of the United States. Plus by dollarizing, Canada would lose their central bank as a lender of last resort in a crisis to bail out domestic banks and other financial institutions.  Though from the Canadian viewpoint, monetary union seems desirable over dollarization when it comes to monetary policy development, it is still not an option. 
The intensity of economic integration between Canada and the United States is relatively little, regardless of having the largest mutual trading relationship. To decide on a monetary union would be the wrong start at the wrong end of the integration process. Rather it is obligatory to continue to further North American integration through a customs union as a next step in the development. In view of that, the Canadian interests can best be achieved through the implementation of a customs union to gradually deepen the Canadian trade of goods and services. 
Canada considers dollarization as neither essential nor enviable. Canada has had a better inflation record than the United States and does not look at a currency crisis. It is doing exceptionally healthy economically because it is highly integrated in the global economy by both finance and economy. Moreover it pursues positive economic policies. 
In summary, we have argued that the cost of monetary independence is becoming increasingly obvious as Canada shifts into human-capital-led growth and deeper economic integration with the rest of North America.  So a monetary union would be too much to ask for at this point of time. But also the current floating exchange rate system is not working very well for Canada. Though a flexible exchange rate regime is necessary if Canada wants to pursue a different inflation rate than the United States, for the above named arguments a fixed exchange rate system seems to be the most favorable one right now.