Study: Domestic and foreign influences on Canadian prices over exchange rate cycles

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This new study examines factors, both domestic and foreign, that had an impact on how 81 Canadian manufacturing industries set their prices between 1974 and 1996, and specifically the impact of cycles in the exchange rate.

It found that both Canadian producers and importers adjusted their prices downward during periods of appreciation in the exchange rate, though less than proportionately to the rate of appreciation of the Canadian dollar.

The actual benefits that consumers receive from an appreciating Canadian dollar depend on whether importers pass on the lower prices that they pay for their goods in the United States, and the extent to which Canadian manufacturers choose to meet these lower prices.

(Since 2002, the value of the Canadian dollar has increased by around 30% against its US counterpart. This makes American manufactured goods less expensive in Canada.)

When the Canadian dollar depreciated, as it did between 1974 and 1986, and between 1991 and 1996, products from the United States became relatively more expensive and offered less of a competitive threat to Canadian producers.

The study found that the prices of goods in Canada, either produced at home or imported, also went up, but by less than the amount that would have fully reflected the change in the exchange rate.

When the Canadian dollar appreciated, as it did between 1986 and 1991, products from the United States became relatively cheaper and offered more of a competitive threat. The prices of goods in Canada, both those produced domestically and imported, went down, but by less than the amount that would have fully reflected the change in the exchange rate.

Besides the influence of competing US prices, the study found that changes in Canadian prices also reflected changes in production input prices (such as the price of labor, energy and material), changes in productivity and in the general strength of the economy.

Prices of products imported to Canada were more responsive to competing US prices, compared to prices of domestic products. However, in pricing their imports to Canada, importers did not merely pass-through all changes in import costs. They also adjusted to conditions in Canadian markets.

Competition matters. The intensity of competition and the pressures originating from movements in the exchange rate are related to the types of adjustments made and the speed of adjustment.

Prices for domestic products are more sensitive to foreign prices if the industry faces higher import competition from US producers and if home and foreign products are less differentiated. Differentiated products are less homogeneous and are more heavily advertised.

Likewise, if an industry faces lower competition, either lower competition from importers of foreign products or lower competition from rival firms in the domestic market (fewer firms, higher concentration and less firm turnover), changes in Canadian output prices are most likely to reflect changes in domestic costs and are less likely to respond to import competition. An industry with higher market power passes on more of its increases in costs and less of its productivity gains to its output prices.

The pressures emanating from the exchange rate also affect the nature of the adjustment process. When the Canadian dollar is depreciating, Canadian industries are under less pressure from foreign prices. When it appreciates, they face more foreign pressure.

Domestic output prices and import prices respond more to domestic cost changes in a period a depreciating Canadian dollar, but more to foreign price changes in a period of an appreciating Canadian dollar.

The speed of adjustment of Canadian prices to changes in domestic costs or foreign prices also differs depending on whether the Canadian dollar is depreciating or appreciating. The speed with which Canadian industries adjust is reduced when they face less pressure and increases when they face more pressure from movement in the exchange rate.

Note: Data for this study came from the National Bureau of Economic Research and Center for Economic Studies (NBER-CES) productivity database and databases developed at Statistics Canada. Information on US industrial output prices was from the NBER-CES productivity database. Measures on industry characteristics, output prices, input prices and productivity were obtained from the Micro-economic Analysis Division. Import prices were from the Input-Output tables.

The research paper "Domestic and foreign influences on Canadian prices over exchange rate cycles, 1974 to 1996" is now available as part of the Economic Analysis Research Paper Series (11F0027MIE2006043, free) from the Publications module of our website.

More studies related to the influence of the exchange rate on Canadian prices are also available in the analytical series Update on Economic Analysis (11-623-XIE, free) on our website. In particular, see Integration and Co-integration: Do Canada-US Manufacturing Prices Obey the "Law of One Price?" no. 29 (11F0027MIE2005029) and Purchasing Power Parity: A Canada/US exploration, no. 2 (11F0027MIE2002002) and "Do Canadians pay more than Americans for the same products?" in the Canadian Economic Observer, Vol. 16, no. 5 (11-010-XIB, free), available from the Publications module of our website. A print version of Canadian Economic Observer (11-010-XPB, $25/$243) is also available.

For more information, or to enquire about the concepts, methods or data quality of this release, contact John R. Baldwin (613-951-8588), Micro-economic Analysis Division.