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The Inflow of Long-Term Capital and the Canadian Business Cycle 1950–1960*

  • Rudolph G. Penner (a1)

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Canada's recent return to a pegged exchange rate marks the end of a highly interesting experiment in international economic policy and the end of an era in the history of the Canadian balance of payments. It is now appropriate, therefore, to look backwards and to examine the effects of changes in the balance of payments on the Canadian economy during the period in which the value of the Canadian dollar was allowed to fluctuate freely. Only a very narrow aspect of the problem is examined in this paper, namely, the effect of the large long-term capital inflow of the 1950s on the Canadian business cycle. This problem is interesting not only for its own sake, but also because the cyclical effect of a capital inflow is extremely important in determining whether the borrowing country achieves its potential or required growth rate.

If, for our purposes, we define the potential supply of goods and services available to an economy as domestic production at full employment plus imports minus exports, a capital inflow increases that supply by bidding up the value of the Canadian dollar until sufficient upward pressure on imports and downward pressure on exports is imposed to transfer the capital inflow in real terms. This increase in supply implies that planned aggregate expenditures in Canada can increase without exerting inflationary pressures on the economy. A capital inflow allows a higher level of investment expenditure and this raises the potential rate of growth of the productive capacity of the economy.

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This is a revised version of a paper presented to the annual meeting of the Canadian Political Science Association, June 8, 1962. I would like to thank Professors S. C. Tsiang, Harry G. Johnson, and T. L. Powrie for comments on an earlier version of this paper.

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1 The term “required rate of growth” is used in the same way as it is used by Domar, E. D. in “Expansion and Employment,” American Economic Review, XXXVII, no. 1, 03, 1947 , reprinted in Domar's, Essays in the Theory of Economic Growth (New York, 1957), 83108. A similar growth model is used by Ingram, James C. to analyse the effect of international capital flows in “Growth in Capacity and Canada's Balance of Payments,” American Economic Review, LXVII, no. 1, 03, 1957, 93104.

2 Only if this occurred would Tames Coyne's famous phrase, “living beyond our means,” have any meaning. See his speech before the Canadian Club of Winnipeg, Jan. 18, 1960, which has been mimeographed by the Bank of Canada.

3 This assumption seems to lie behind the analysis of Barber, Clarence L., “Canada's Unemployment Problem,” this Journal, XXVIII, no. 1, 02, 1962, 101. Barber's term capital inflow includes short-term flows and undoubtedly the large inflows of the latter occurring because of the phenomenal short-term interest differential existing during parts of 1959 and 1960 did exert deflationary pressures on the economy. Mr. Fleming in his budget message of June 20, 1961 rightly stated that inflows into already existing Canadian assets tended to be deflationary. See Canada, House of Commons, Debates, CV, no. 135, p. 6645. See also Hood, Wm. C., “A Comment on the Decline in the Rate of Economic Growth,” Commerce Journal, published by the University of Toronto Commerce Club, 1961, p. 19. For an extreme view, see Coyne, James, “Foreign Debt and Unemployment,” speech delivered to the Canadian Club of Toronto, 11 14, 1960 , mimeographed by the Bank of Canada.

4 The importance of leads and lags in these relationships is ignored until later in the paper.

5 This effect was first pointed out by Laursen, S. and Metzler, L. A., “Flexible Exchange Rates and the Theory of Employment,” Review of Economics and Statistics, XXXII, no. 4, 11, 1950, 281–99.

6 The importance of a substitution effect was pointed out by Pierce, I. F., “A Note on Mr. Spraos' Paper,” Economica, new series XXII, no. 86, 05, 1955, 148. Of course there is no substitution effect if we assume that future consumption is identical to present consumption. The problem of the target saver, the residual saver, and the fixed-ratio saver are ignored in this paper. For an account of these, see Musgrave, R. A., The Theory of Public Finance (New York, 1960), 264–8.

7 In the interests of simplicity, I have implicitly assumed that no intermediate goods are imported, and therefore, the effect of changes in this type of import on savings and investment is not considered.

8 Estimate made from data provided by Slater, David W., Canada's Imports, Royal Commission on Canada's Economic Prospects (Ottawa, 1957), 125–8.

9 In a private interview, a government official in a position to be informed on such matters estimated that at least 20 per cent of direct foreign investment entering Canada during the late 1950's was used to finance purchases of established Canadian corporations. Because this figure represents only an informed guess, the official does not want his name to be associated with it.

10 The argument of the last two paragraphs follows that of Machlup, Fritz, International Trade and the National Income Multiplier (Philadelphia, 1943), 151–3.

11 Ibid., 153.

12 Wonnacott, Paul, The Canadian Dollar, 1948–1958 (Toronto, 1961), 123.

13 Rhomberg, Rudolf R., “Canada's Foreign Exchange Market,” International Monetary Fund Staff Papers, VII, no. 3, 04, 1960, 447.

14 C. P. Kindleberger has pointed out an association between short-term capital flows and the income velocity of money in a somewhat different context. See his International Short-Term Capital Movements (New York, 1937), 2632.

15 Wonnacott, , Canadian Dollar, 123.

16 Ibid.

17 Occasionally Canadians borrowing on a long-term basis do not repatriate funds immediately but retain foreign balances until the proceeds of the loan are required. In the balance of payments statistics this would show up initially as a long-term capital inflow matched by a short-term outflow. The repatriation of the funds would then appear as a short-term inflow. My theoretical analysis would then apply to the short-term inflow which would have all of the effects of a long-term inflow including the stimulus to speculation. However, my empirical evidence does not take account of this possibility. I am indebted to T. L. Powrie for making this point.

18 Wonnacott, uses this definition, Canadian Dollar, 45–6, and it is also used by Radford, R. A., “Canada's Capital Inflow,” International Monetary Fund Staff Papers, IV, no. 1, 02, 1955, 237–42.

19 In calculating this table, I omitted data from the last quarter of 1950 and from all of 1951 because during this period the exchange rate still had not entirely adjusted to the freeing of the rate which occurred in September of 1950. Data from 1959 and 1960 were also omitted because of the interference of the large short-term capital movement.

20 The two-way causal relationship may be substantiated by the following relationship between Dt and Lt+1 which is more significant than that obtained in equations (3) and (4).

* This is a revised version of a paper presented to the annual meeting of the Canadian Political Science Association, June 8, 1962. I would like to thank Professors S. C. Tsiang, Harry G. Johnson, and T. L. Powrie for comments on an earlier version of this paper.

The Inflow of Long-Term Capital and the Canadian Business Cycle 1950–1960*

  • Rudolph G. Penner (a1)

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