Is the Canadian Dollar in Secular Decline? Empirical Evidence on Purchasing Power Parity and the Links Between Exchange Rate Volatility, Transborder Capital Flows, and News

The slump of the Canadian Dollar against the U.S. Dollar over the last years has led many observers to speculate that the Canadian Dollar is in secular decline, prompting demands for a U.S.-dollarization or even a common currency for North America. However, there is no robust empirical evidence to support the notion of a ‘secular’ decline. An econometric model of the nominal USD/CAD exchange rate finds instead that the purchasing-power-parity adjustment mechanism is alive and well, but that the Canadian Dollar remains sensitive to commodity-price shocks. Recent years have also witnessed a startling increase in the volatility of the Canadian Dollar. This paper shows that this increase in volatility can be linked to an increase in the volume of cross-border capital flows. There is also an asymmetry through which “bad news” about the Canadian Dollar (i.e., depreciation shocks) lead to larger innovations to volatility than good news, and there is evidence that volatility persistence has increased in the 1990s relative to earlier decades.