Flexible Exchange Rates and Oligopoly Pricing: A Study of Canadian Markets

TLDR: In this paper, the authors show that the usual conclusion that traded goods prices in at least one market must move with the exchange is based on the implicit and unrealistic assumption of perfectly competitive markets, and that the realities of imperfect markets make stable prices likely over a range of exchange rates.

Abstract: The primary purpose of this paper is to demonstrate that a system of flexible exchange rates will not necessarily destabilize the prices of traded goods. It will be argued that the usual conclusion that traded goods prices in at least one market must move with the exchange is based on the implicit and unrealistic assumption of perfectly competitive markets, and that the realities of imperfect markets make stable prices likely over a range of exchange rates. This hypothesis is tested in a study of six markets during Canada's experience with flexible exchange rates between 1950 and 1962. It is not the purpose of this paper to provide a general defense of flexible exchange rates, but instead merely to invalidate the argument that such a system cannot operate successfully for an open economy because too many prices will be forced to shift from day to day to offset exchange rate movements (McKinnon 1963). The numerous other arguments against exchange rate flexibility are not discussed. If perfect competition is assumed, prices can differ between two markets only by transport costs and tariffs; if the two markets have separate currencies, and the exchange rate varies, at least one of the two prices of any traded goods will have to shift to maintain the equality; percentage changes in the relationship between the two prices should equal the percentage changes in the exchange rate.1 This process provides a rather