4.8.2 Exchange Rate

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.