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A high dollar means higher wages, not lower prices

How we’re benefitting from an increase in the Canadian dollar


 

photo illustration by sarah mackinnon

Anyone who has gone cross-border shopping knows that, on average, goods are currently cheaper in the United States than they are in Canada. Recent Purchasing power parity (PPP) data estimates that a bundle of goods that costs a consumer $1 CAD in Canada, costs in the range of 80-85 US cents in the United States. With the Canadian dollar currently trading in the 96-cent range (July 15, 2013), Canadian consumers are paying a significant premium on their goods compared to their U.S. counterparts.

This had led to calls that the Bank of Canada should intervene, with Erin Weir arguing that the Canadian dollar should be pushed down to the PPP value of 80-85 cents, which Weir believes is the fundamental value of the loonie.Christopher Ragan, on the other hand, argues against the idea, insisting the Bank focus solely on inflation (and pushing down on the dollar would escalate inflation). Furthemore, he argues that the PPP does not represent a “fundamental” value for the currency, since currencies are affected by factors other than imports and exports of goods.

Ragan is ultimately correct, though the story should not end here. What this discussion is missing is the interaction between the exchange rate, prices and the Bank of Canada. Canadians have benefited a great deal from the increase in the Canadian dollar, even if they are not seeing lower prices at the register.

First, some history. The Canadian dollar bottomed out in late 2002, then rose quickly, hitting the 80-85 cent PPP level in 2004 and continuing to increase from there.

Weir has argued that the increase in the Canadian dollar has not benefited Canadians:

Yet the OECD calculates that, in 2011, a Canadian dollar bought only as much in Canada as 81.3 American cents bought in the U.S. Strikingly, that ratio was exactly the same back in 2002. In other words, the loonie’s ascent has delivered no apparent improvement in purchasing power.

When the Canadian dollar reached parity with the U.S. dollar in 2007, many commentators cautioned that it could take time for the savings to be passed through to Canadian consumers. However, the loonie has now been near parity for four of the past five years… [we] are still waiting for the promised benefits of a high-flying loonie.

The idea that there has been no improvement in the purchasing power of Canadians is false, but it is an easy mistake to make since it is not showing up in the obvious place: prices.

Suppose the Canadian dollar rises, causing Canadian prices (in Canadian dollars) to rise above U.S. prices (in U.S. dollars). When this happens, deflationary pressures are created which should cause Canadian prices to fall, as importers are paying less for goods imported from the U.S. and some Canadian consumers have the ability to cross-border shop. However, since the Bank of Canada has a 2% inflation target, it cannot not allow these deflationary pressures to go unanswered. The Bank will respond by increasing the money supply until inflation returns to the 2% level. Because of the increase in the money supply, overall prices do not fall.  Since the U.S. and Canada both have similar inflation targets, the relative prices between Canada and the U.S. should not deviate too much, regardless of the level of the exchange rate. We should not be surprised that the PPP level does not change much, since it cannot change if two countries have identical levels of inflation.

To reiterate, when the Canadian dollar is above the PPP exchange rate, goods are cheaper in the U.S. than in Canada. This puts deflationary pressure on prices in Canada, since imports are relatively less expensive when priced in Canadian dollars. We should expect the Bank of Canada to respond to these deflationary pressures by increasing the money supply. Which is exactly what happened:

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The above chart shows total growth (non-annualized) over a three-year period in the M2 money supply in both Canada and the U.S. (Data from Trading Economics)  M2 is a broad definition of money that includes money in chequing and savings accounts, along with non-institutional money-market funds. There is a great deal of volatility in the M2 money supply data even year-to-year, so I prefer to look at a three-year increase of the money supply.

However, the one-year growth data show a similar pattern (data begin from April 1993 to make it comparable to the three-year growth series above that begins in 1996):

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Both graphs show the same effect.  Starting in 1999, the rate of growth of the Canadian money supply increased and stayed high first due to a catch-up effect of past slow growth (1999-2000).  Normally a 6% growth rate in M2 would be highly inflationary (and Canada did experience periods of over 3% inflation in mid-2001 and late 2002-early 2003). However, the Bank of Canada was able to maintain this level of monetary growth post-2002 thanks to the deflationary pressures put on the Canadian economy as a result of the high dollar.

But where did all this money go? Some of it went into foreign exchange markets, preventing the Canadian dollar from rising even faster. But much of it went into the pockets of workers:

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The measure above is average hourly earnings for employees paid by the hour. This is another series where I prefer to look at a three-year non-annualized growth rate to eliminate any year-to-year volatility in the data. The wages here represent the average hourly earnings for employees paid by the hour, measured in Canadian dollars, also available from Trading Economics.

The methodology each country uses to measure hourly wages differs greatly, so I was hesitant to include the U.S. series. However, for completeness, here is the U.S. data, Average Hourly Earnings of Production and Nonsupervisory Employees (measured in U.S. dollars). Since the methodologies for the two series differ greatly, a direct comparison should be taken with about a pound of salt. The trends in each series is more telling, with Canada entering a sustained growth trend around 2003 which was not matched by the United States.

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Normally, we would expect to see a reduction in the rate of inflation when the Canadian dollar is above the PPP level. However, the Bank of Canada’s monetary target prevents this from happening. But that does not mean Canadian consumers do not benefit from a high Canadian dollar. Due to the actions of the Bank of Canada, the benefit comes in the form of higher wages rather than lower prices. An increase in the purchasing power of Canadians is a good thing, whether it comes from wages or prices.

Mike Moffatt is an assistant professor in the Business, Economics and Public Policy group at the Richard Ivey School of Business, University of Western Ontario


 

A high dollar means higher wages, not lower prices

  1. Consider the case of Target expanding into Canada. Do you believe their business case for expansion includes higher prices paid by Canadians relative to the US simply because Canadians willingly pay more?

    I think it does. Economies of scale and competition also factoring into the equation.

  2. Yeah, that pound of salt can go a long way, can’t it ?

    But those guys and gals at PEF are just so .. er ..

    “progressive” and .. er .. wrong, aren’t they ?

    I stand by for the next skirmish. You know it’s coming.

  3. As a consumer, it seems clear to me that the reason we are not getting lowered prices is because retailers want to keep their profit margin as big as possible. They have no desire to pass on the cheaper prices of goods to us consumers. And that’s fine because thanks to the current government, each Canadian can now bring back $800 worth of goods after staying in the US for a 48 hour period. Thank you Stephen Harper. This is easily the best decision your government made. Better still, the actual choice of goods is far superior in the US as well. Take that Canadian retailers!

    • Retailer margins are about the same or smaller (due to intense competition in some markets). There are some country pricing shenanigans with manufacturers charging Canadians higher prices (Tylenol, for instance) than is justified by the exchange rate and distribution costs.

      • Can also be the distributor (say Walmart) that makes margins appear smaller through transfer pricing.

        • I doubt that’s it, to any significant extent. Walmart competes locally against domestic companies, whose margins haven’t risen with the rising dollar.

          • Walmart’s key success factor (in the US) has been largely due to its distribution chain management /IT system – and squeezing costs from its increasingly Chinese suppliers. Economies of scale in purchasing reduces costs not available to smaller, local distributors.

            I seem to recall Target, when announcing expansion plans into Canada, indicated the prices typically will be higher than in the US. So, they control transfer price. The level they choose will be determined, in part, by costs (which could include higher wages) and competition/volume.

          • The reason why Target’s prices are higher in Canada than the US is in large part due to national brand manufacturers charging more for goods made for the Canadian market. Target can’t import tylenol made for sale in the US to sell in Canada due to differing labelling regulations. This is true for most products, exceptions being control brand products. Target and Walmart’s advantage over the big Canadian retailers in this regard might be a few percentage points at most (which would be huge for their profit margins), but too small to make much meaningful impact for Canadian consumers.

          • I suspect pharmaceuticals and food requiring local labelling constitute a small portion of their sales (but haven’t checked).

            Furniture, clothing, sporting goods, consumer electronics (ULC/CSA) etc. would not have similar restrictions.

      • A good example is check the price of Microsoft Windows on their Canadian site and the USA site. Huge increase in Canada.

        • It’s due to the Canadian english spell checker.

          • lol

          • Wouldn’t all language settings worldwide for Windows be a sunk cost by now? There should be no difference in price whether in the US, Canada, Britain, Bahrain or Paraguay.

          • Yeah, I was joking.

            The marginal cost of producing a Windows CD would be, what, a few bucks? Microsoft will sell it at whatever price the market will bear. Within reason (the majority it should be noted would be to OEMs – the Dells, HPs etc.)

  4. It seems to me that maintaining the disparity in prices while reducing the disparity through wages might end up being the same for a typical Canadian earner, but sooner or later it would be better if the act of crossing the border did not make you suddenly richer or suddenly poorer.
    This would mean that the persistent and irrational fear of deflation would have to be ended, or we would have to wait for a long period of time until the US finally experienced a higher rate of inflation for a while.

  5. get rid of FRENCH LABEL REQUIREMENT. Prices will come down.

    • Give me a break. The cost to add French to a label must be a fraction of a penny per unit. Also, in case you haven’t noticed, most hard goods sold in North American now are labelled in English, French and Spanish because of a rising middle class in Mexico.

  6. Why can I buy Canadian made products cheaper in the US verse Canada?

    I lived in a Canadian border town and could travel to the US and by Canadian made cheese and beer cheaper in the US then in Canada, why? 1 kilometer away and the price change significant.

    • Taxes are a large part of it. Look at Gas prices for example. Canada is by far the largest exporter of oil to the US (http://www.eia.gov/petroleum/imports/companylevel/) yet gas is much more expensive here? Look at the breakdown of the cost of gas. Now you factor in how much gas is used everywhere and you can see part of the problem.

      PS.
      I bought a set of snow tires in the US a while ago. Right on the side it said “made in Canada” and yet they cost almost 30% less in the states? Nothing like buying your own product for less in another nation.

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