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.