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I'll try a scenario to see if it helps. Let's say for whatever reason the BoC had an extremely tight stance and so the loonie is scarce. In contrast at the time the peg is established the Fed has a much looser stance. So BoM struggles to attract funds at a sufficiently low rate to grow. Citibank has a very low cost of funds. An arbitrage exists which drives Citi to lend to BoM in the interbank market and then redeem with the Fed. Then the fed must settle at par. The fed has a problem controlling inflation. So yes the BoC controls monetary policy of the USA in this example, even though the US is much bigger. Doesn't Germany have this problem now too?
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Apr 4, 2012