SEMI-NONPARAMETRIC ESTIMATES OF CURRENCY SUBSTITUTION BETWEEN THE CANADIAN DOLLAR AND THE U.S. DOLLAR

Abstract

In this paper we investigate the issue of whether a floating currency is the right exchange rate regime for Canada or whether Canada should consider a currency union with the United States. In the context of the framework recently proposed by James L. Swofford, we use a semi-nonparametric flexible functional form—the asymptotically ideal model (AIM), introduced by William A. Barnett and A. Jonas—and pay explicit attention to the theoretical regularity conditions of neoclassical microeconomic theory, following the suggestions of William A. Barnett and William A. Barnett and Meenakshi Pasupathy. Our results indicate that U.S. dollar deposits are complements to domestic (Canadian) monetary assets, suggesting that Canada should continue the current exchange rate regime, allowing the exchange rate to float freely with no intervention in the foreign exchange market by the Bank of Canada.