4.8.2 Exchange Rate

In this section, we discuss the exchange rate, its impact on the Canadian economy, and the key determinants influencing currency values.

The Exchange Rate

Buying foreign goods or investing in a foreign country requires the use of another currency to complete the transactions. Likewise, when foreign buyers purchase Canadian goods or invest in Canadian assets, they need Canadian dollars. The foreign exchange market encompasses all places where one nation’s currency is exchanged for another at specified exchange rates. The exchange rate is the existing price of one currency in terms of another.

For example, at a given time, it might cost $0.71 U.S. dollars to buy one Canadian dollar, while at the same time it would cost $1.41 Canadian dollars to buy one U.S. dollar.

To put it simply:

  • To buy 1 CAD, you need $0.71 USD.
  • To buy 1 USD, you need $1.41 CAD.

Exchange Rate and the Canadian Dollar

The value of the Canadian dollar relative to other currencies influences the economy significantly, primarily through trade. A higher Canadian dollar makes Canadian exports more expensive in foreign markets while making imports cheaper in Canada. This situation occurs if the Canadian dollar appreciates. Conversely, if it depreciates, Canadian exports become cheaper, and imports more expensive.

Example

Assume a Canadian-made machine sells for $1,000 in Canada. With an exchange rate of CAD $0.71 USD, the machine will sell for $710 in the United States. If a similar product sells for $775 in the U.S., the Canadian manufacturer benefits since its machine sells for a lower price given the exchange rate. However, if the exchange rate appreciates to $0.79 USD, the machine will sell for $790, making the Canadian manufacturer less competitive.

Exchange Rate Trend Between Canada and the United States

    graph LR
	  A[1975] --> B[1980]
	  B --> C[1985]
	  C --> D[1990]
	  D --> E[1995]
	  E --> F[2000]
	  F --> G[2005]
	  G --> H[2010]
	  H --> I[2015]
	  I --> J[2020]
	  E((Depreciation from 1975-2002))
	  E((Appreciation from 2003-2007))
	  I((Recent Depreciation))

The Bank of Canada’s data indicates that the Canadian dollar depreciated against the U.S. dollar from 1975 to 2002, except for a short period in the late 1980s when it appreciated. From 2003, the currency rose steadily, often trading above USD 1.00 for 2007. However, it has recently depreciated.

Determinants of Exchange Rates

Many economists and analysts keenly follow changes in exchange rates. Though some countries fix their currency’s value relative to their major trading partner, Canada allows its exchange rate to float.

The following factors affecting exchange rates are often debated:

Commodities: Canada’s economy depends heavily on commodity exports. Increased demand for Canadian products drives the demand for Canadian dollars higher.

Inflation: Currencies of countries with lower inflation rates generally rise because of their increasing purchasing power.

Interest Rates: Central banks influence exchange rates by adjusting nominal interest rates. Higher interest rates attract foreign investment, boosting the currency value, whereas lower rates discourage foreign investments.

Trade: When exporting goods, foreign buyers need Canadian dollars, raising its value. Conversely, importing goods floods the market with Canadian dollars, reducing its value.

Economic Performance: Robust economic growth attracts foreign investors, boosting the currency’s value.

Public Debts and Deficits: Countries with large debts and deficits are less attractive to foreign investors.

Political Stability: Political stability makes a country’s currency more inviting to investors, while instability leads to a flight to quality towards stable currencies.

Key Terms & Definitions

  • Exchange Rate (FX Rate): The price of one nation’s currency in terms of another’s.
  • Appreciation: Increase in value of one currency relative to another.
  • Depreciation: Decrease in value of one currency relative to another.
  • Commodity: Raw materials and primary agricultural products that can be bought and sold.
  • Inflation: Rate at which the general level of prices for goods and services rises.
  • Interest Rate: The proportion of a loan charged as interest to the borrower. GUI calculations Example: $0.71 USD/CAD  1 CAD Note that appreciation % goes up.

Key Takeaways

  1. Impact of the Canadian Dollar: The strength or weakness of the Canadian currency versus other currencies significantly impacts both trade and economic health.
  2. Interconnected Factors: Commodity prices, inflation, interest rates, trade balances, economic performance, governmental debt, and political stability all play complex roles in determining the exchange rate.
  3. Understanding Trends: Historical currency trends provide essential insights for better planning in trade and investment.

Complete the chapter’s online learning activities to reinforce these concepts and test your knowledge.


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## What does the exchange rate represent? - [ ] The perpetual growth rate of an economy - [ ] The inflation rate of a country - [x] The current price of one currency in terms of another - [ ] The interest rate set by a central bank > **Explanation:** The exchange rate is the current price of one currency in terms of another, determining how much of one currency is needed to exchange for another. ## How does a higher value of the Canadian dollar relative to other currencies generally affect Canada? - [ ] Makes Canadian exports cheaper in foreign markets - [x] Makes Canadian exports more expensive in foreign markets and imports cheaper in Canada - [ ] Increases Canadian inflation rates - [ ] Causes the Canadian central bank to decrease interest rates > **Explanation:** When the Canadian dollar strengthens relative to other currencies, Canadian goods become more expensive in foreign markets and imports into Canada become cheaper. ## What happens when the Canadian dollar appreciates against the U.S. dollar? - [ ] The Canadian dollar becomes cheaper in terms of U.S. dollars - [ ] The Canadian dollar experiences a loss in purchasing power - [x] The Canadian dollar increases in value relative to the U.S. dollar - [ ] The Canadian dollar becomes less competitive in the domestic market > **Explanation:** An appreciation of the Canadian dollar means its value increases relative to the U.S. dollar, making Canadian goods more expensive in the U.S. market. ## What factor is considered one of the strongest influences on the Canadian exchange rate? - [x] Commodities - [ ] Political stability - [ ] Inflation rate - [ ] Public debts > **Explanation:** The price level of commodities is a significant influence since Canada is heavily dependent on the export of natural resources. ## How do higher domestic interest rates generally affect the exchange rate? - [ ] They have no impact on the exchange rate - [ ] They lead to a decrease in the value of the currency - [x] They attract capital and lift the exchange rate - [ ] They lessen the purchasing power of the currency > **Explanation:** Higher domestic interest rates attract foreign capital, raising the demand for the domestic currency, which in turn lifts the exchange rate. ## What impact does political stability have on a country’s currency? - [ ] It generally causes depreciation of the currency - [x] It improves investor confidence and supports a stronger currency - [ ] It reduces the inflation rate - [ ] It has no influence on the currency value > **Explanation:** Political stability enhances investor confidence, making the country's currency more attractive and potentially increasing its value. ## Why are countries with consistently lower inflation rates said to have rising currencies over time? - [x] Because their currencies reflect increased purchasing power - [ ] Because they often have higher interest rates - [ ] Because they export more goods - [ ] Because they have more political stability > **Explanation:** Lower inflation rates increase a currency's purchasing power relative to other currencies, causing it to appreciate over time. ## How does Canada typically manage its exchange rate? - [ ] By fixing the value of its currency to a major trading partner - [ ] By frequently intervening in the foreign exchange market - [x] By allowing its currency to float freely - [ ] By setting predetermined exchange rates > **Explanation:** Canada allows its currency to float freely and generally does not intervene to support the Canadian dollar, except to potentially stabilize rapid changes. ## What is the relationship between trade and the value of the Canadian dollar? - [ ] Higher imports increase the value of the Canadian dollar - [ ] Exports decrease the value of the Canadian dollar - [x] Exports increase the value of the Canadian dollar; imports increase the supply of Canadian dollars, causing downward pressure on its value - [ ] Trade has no impact on the Canadian dollar > **Explanation:** When Canada exports goods and services, the demand for Canadian dollars rises, increasing its value. Conversely, imports lead to a higher supply of Canadian dollars, putting downward pressure on its value. ## Which of the following is likely to attract foreign investment to Canada? - [ ] High public debts and deficits - [ ] Low domestic interest rates - [x] Strong economic performance and higher investment returns - [ ] Political instability > **Explanation:** A strong economic performance and the potential for higher returns make Canada more attractive to foreign investors.

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Tuesday, July 23, 2024