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The argument has frequently been made that fixed exchange rate systems allow the transmission of foreign economic disturbances to the domestic economy through a variety of channels. One of the reasons cited for the breakdown of fixed exchange rate regimes in the past has been the unwillingness of countries to 'import' recession from the rest of the world. This paper investigates the insulating properties of fixed exchange-rate systems by examining the transmission of US income disturbances to Canada under the Bretton Woods System during the period 1962 to 1970. The well-known strength of the trade and capital-flow relationship between Canada and the US provides a useful case study of the operation of the transmission mechanism: Disturbances originating in the larger US economy will be transmitted to the Canadian economy to a quantifiable extent if the fixed exchange rate system encourages avenues of transmission.
Two main channels of transmission of foreign economic disturbances under fixed exchange rates are examined. The model contains an aggregate demand channel in which domestic income is affected through the home country's exports, which in turn depend on foreign income. Consider, for example, a fall in foreign income which induces a decline in home exports. Under fixed exchange rates the disturbance is transmitted to the home country as a deterioration in its trade balance due to falling export demand and, consequently as a reduction in domestic income. Under a flexible exchange rate system, the incipient deterioration in the home country's trade balance results in a depreciation of the home currency, offsetting to some degree the income-induced fall in export demand. Thus, traditional economic theory suggests that fixed exchange regimes facilitate the transmission of undesired foreign income shocks. [ABSTRACT FROM AUTHOR]