Exchange Rate Arrangements for NAFTA: Should we mimic the EU, and if so, how?
Patrick M. Crowley, Middlebury College, and J.C.Robin Rowley, McGill University

The objectives of the paper are to study possible North American exchange rate arrangements which would aid and further development of a more integrated NAFTA, using quantitative methods but placed within a sensible institutional framework.

One of the most important stepping stones for European Monetary Union, and the coordination of economic policies in the EU, was the establishment of the European Monetary System (EMS) in 1979. In particular the exchange rate mechanism (ERM) of the EMS was used to tie most EU member state exchange rates to one another through a bilateral grid. This was used to promote economic convergence, and as a criteria for going forward to adopt the euro in 2002. For further economic integration to occur in North America, it may be necessary to introduce new exchange rate arrangements for the continent so as to stabilize trade flows and to properly coordinate economic policy.

Using the parameters from a GARCH model on exchange rates in the exchange rate mechanism of the EMS we use exchange rates for the Mexican peso and the Canadian dollar to simulate movements in the currencies within a target zone exchange rate type system. When the simulated exchange rate hits the edge of the band, we assume a realignment would have occurred. Obviously some sensitivity analysis will have to be performed on the parameters for the target zone framework, and this will also be included in the analysis.

We expect to show that both the Canadian dollar and the Mexican peso, if tied to the dollar through a target zone system of exchange rates, would have resulted in substantially less volatility than with the current (non-) arrangements. In turn this would have probably have resulted in more trade, higher corporate profits and consequently higher growth rates for both Canada and Mexico.

Although North American Monetary Union (NAMU) has been discussed extensively in Canada, this debate has not really percolated down to the US, so this paper is an attempt to use existing data and a model of exchange rate volatility to analyze the issue in a NAFTA context.

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