The Canadian Dollar: Nature and Impacts of Canadian Exchange Rates
The value of the Canadian dollar relative to other national currencies plays an important role in the political and economic life of the nation. However, it is not often clear exactly how the price of the dollar is determined, or what role governments and other financial actors play in this process. This article provides an introduction to the process of valuing the Canadian dollar relative to other nations' currencies. Specific topics discussed include the modern system of currency exchange, market and government influences on the value of the dollar, as well as important economic, political, and social consequences caused by changes in the dollar.
Exchange rates and the modern floating exchange system
The dynamics of supply and demand relating to the Canadian Dollar
Monetary policy and government intervention
Economic, social and political impacts of Canadian exchange rates
List of article sources and links for more on this topic
Valuing the Canadian Dollar Relative to Other Currencies
Exchange rates and the modern floating exchange system
What are Exchange Rates?
When financial observers report the Canadian dollar has gone up or down, they are usually referring to changes in the dollar’s “exchange rate” (also known as the foreign exchange rate, the forex rate, or the FX rate). An exchange rate is simply the rate at which one national currency may be exchanged for another (hence, the term exchange rate). In other words, it is a measurement of the value or price of one currency in comparison to another.
Take the following example: you are a Canadian tourist wanting to travel to the United States; as such, you will need to exchange your Canadian dollars for American ones. Let’s say the Canada-US exchange rate (or the rate at which Canadian currency is exchanged for American funds) is US $0.89. This means that for every Canadian dollar you exchange you would get 0.89 American dollars in return. Hence, if you were to exchange $100 Canadian dollars, you would get $89 American dollars.
This same rate can also be expressed, conversely, as a US-Canada exchange rate (or the rate at which American currency is exchanged for Canadian funds). A US $0.89 Canada-US exchange rate, for example, would approximate a CAN $1.12 Canada-US exchange rate. This means that for every American dollar a US tourist exchanges for Canadian funds, s/he would receive 1.12 Canadian dollars. Hence, if that tourist exchanged $100 American dollars, s/he would get $112 Canadian dollars in return.
While the most common means of tracking changes in the value of the Canadian dollar is by comparison to its American counterpart (or the Canada-US exchange rate), it is important to remember there are as many Canadian exchange rates as there are currencies in the world. Moreover, the Canadian dollar can increase in value in comparison to one currency, but decrease in value relative to another. It may be, for example, that the Canadian dollar is rising relative to the American dollar, but falling in comparison to the European Union Euro or the British pound.
Early Exchange Systems: Gold Standard & Bretton Woods
This raises the question: how are exchange rates determined? For most of Canada’s early history, its currency exchange rates were set through various fixed exchange regimes; first the International Gold Standard and then the Bretton Woods System. Under these exchange regimes the Canadian government would set a particular value for the Canadian currency relative to other currencies, and then undertake certain actions to ensure the dollar stayed “fixed” at that value (hence, the term “fixed exchange system”).
For more information on past fixed exchange regimes:
- The University of Iowa: What is the Gold Standard?
- Routledge Encyclopedia of International Political Economy: Bretton Woods
- Bank of Canada: History of the Canadian Dollar
Current Exchange System: Currency Markets & Floating Rates
Since the early 1970s, however, Canada has participated in a floating (or flexible) exchange system in which the price of its currency is dictated, in large part, by currency exchange markets. A currency exchange market is a stock market for national currencies. It is where governments, state banks, commercial banks, multinational corporations, and currency speculators go to buy and sell different national currencies. Moreover, as in any open market, the value of currencies is determined in large party by the economics of supply and demand. When demand is high and supply is low, the price of a currency will tend to rise. In contrast, when demand is low and supply is high, the price will tend to fall.
For more information on foreign exchange markets:
- Federal Reserve Bank of New York: The Foreign Exchange Market
- Bank of Canada: History of the Canadian Dollar
Today, most governments, including Canada’s, allow international currency markets a large role in determining the exchange rates of their currency. This sort of exchange rate system is referred to as “floating the currency,” hence the reason for the term “floating exchange system.” This does not mean that governments are complete bystanders in the modern exchange system. The Canadian government, for example, may still intervene in currency markets to moderate sharp market shifts or to pursue limited economic or financial goals. Nevertheless, Canada no longer attempts to keep its currency “fixed” at a particular rate relative to the currencies of other countries.
- See the Market Influences on the Canadian Dollar section of this article for more information on the dynamics of supply and demand in the currency market.
- See the Government Influences on the Canadian Dollar section of this article for more information on government intervention in a floating exchange market.
Market Influences on the Canadian DollarThe dynamics of supply and demand relating to the Canadian Dollar
As discussed earlier, Canada participates in a floating exchange system in which the market forces of supply and demand dictate, in large part, the value of its currency. What are the dynamics of these supply and demand forces?
- See the Valuing the Canadian Dollar Relative to Other Currencies section of this article for more information on the floating exchange system.
Business Activity in the Canadian Economy
One of the most important forces affecting the supply and demand for the Canadian dollar is the general level of business activity in the economy. Increases or decreases in the level of business activity, relative to other national economies, can often have a corresponding impact on supply and demand for the dollar and its value relative to other currencies. When business activity increases (there are more businesses operating, producing and selling more goods and services, and employing more workers), demand for the Canadian dollar rises in order to cover the higher levels of activity. If supply is not adjusted accordingly, then the price of the dollar relative to other currencies may also increase. Similarly, if the level of business activity decreases, then demand for the Canadian dollar follows suit. If the supply is not adjusted accordingly, then the value of the dollar may fall relative to other currencies.
Movement of International Investment
Another closely related factor is the movement of investments in and out of the Canadian economy. Every day companies, financial institutions, and individuals make investments around the world, be it purchasing foreign stocks and bonds, buying foreign exports, or engaging in business activities in another country. Changes in the flow of these investments between Canada and other countries can, in turn, impact the value of the Canadian dollar.
Take the following example: an American investor decides to sell his/her American stocks and buy Canadian ones. S/he begins by liquidating his/her American stocks into American currency. In order to buy the Canadian stocks, however, s/he must first acquire Canadian dollars — which takes place by exchanging the American dollars for Canadian ones in the currency exchange markets. Once those Canadian dollars are in hand, Canadian stocks can be purchased accordingly.
A similar process occurs whenever any foreign investor makes an investment in Canada, be it the buying of stocks or bonds, making a business investment, or purchasing Canadian exports. In order to make these investments in Canada, the foreign investor must first acquire the necessary Canadian dollars in the international currency markets. Growth in the level of foreign investments, therefore, result in increased demand for the Canadian dollar. If the supply of the dollar is not adjusted accordingly, then its price may also rise in value relative to other currencies.
An opposite effect can occur whenever investments leave the country. This happens when there is a downturn in foreign purchases of Canadian stocks, bonds, businesses or exports, or when there is growth in Canadian investments in other parts of the world. This causes lower demand for the Canadian dollar and an increase in its supply, resulting in a lower price unless the currency supply is adjusted accordingly.
Speculative Trading & the Canadian Dollar
Just as in stock markets, there is also a high level of speculative activity in international currency markets. Many investors trade national currencies — not because they need them to make actual business investments, but because they looking to make profits on changes in the value of currencies over time. These investors will buy large amounts of a currency on the speculation that it will increase in value over time, and that they will be able to sell the currency for a profit at a later date.
These speculative activities can impact the price of the Canadian dollar relative to other currencies. When speculative investors believe the price of the Canadian currency will increase over time, they will change their holdings from other currencies to the Canadian dollar. This, in turn, increases demand for the Canadian dollar and will consequently increase its price relative to other currencies, if the supply is not adjusted accordingly. Similarly, if speculative investors believe the dollar is weak and will lose value over time, then demand will fall and supply will rise as investors sell off their investments. This, in turn, can result in a sharper decrease in the price of the Canadian dollar relative to other currencies.
Government Influences on the Canadian DollarMonetary policy and government intervention
What is Monetary Policy?
While the Canadian government participates in a floating exchange system, this does not mean it is a complete bystander in regard to the value of its currency. In fact, the Government of Canada regularly intervenes, both directly and indirectly, in the currency exchange markets to influence the supply and demand of its currency and also, in turn, the price of the Canadian dollar relative to other currencies.
These government policies and activities regarding its currency are commonly referred to as “monetary policy.” While the Canadian government today no longer pursues a monetary policy in which it attempts to keep the price of the Canadian dollar fixed or pegged relative to other currencies, it nevertheless has important monetary objectives. For example, it is usually the case that the government will prefer slow and moderate changes in the market value of its currency rather than drastic and extreme ones. The government may also prefer the Canadian dollar to be neither too weak nor too strong relative to the currencies of important trading partners or foreign investors.
Bank of Canada & Monetary Policy
Who exactly in the Canadian government oversees the nation’s monetary policy? The answer is the Bank of Canada, the nation’s central bank. The Bank of Canada observes and analyzes domestic and international economic/financial trends and highlights important national goals. Moreover, it has the authority to manipulate important financial levers, such as the money supply and interest rates, in order to achieve these goals and objectives. As such, the Bank of Canada plays a significant role in the economic and financial life of the country, and has a great influence on the value of the Canadian dollar.
For more information on monetary policy and the Bank of Canada:
Regulating the Money Supply
How exactly does the Bank of Canada influence the price of the Canadian dollar? One way is through direct manipulation of the money supply in currency exchange markets. The Bank of Canada accomplishes this by buying and selling Canadian currency in the market in order to adjust the supply of dollars available for investors and speculators.
Take, for example, a situation in which market investors and speculators are selling off their holdings of Canadian dollars in large quantities. Such a situation could lead to a drastic fall in the price of the Canadian dollar, as demand weakens and a flood of Canadian dollars hit the market. In order to moderate this change in price, the Bank of Canada will intervene by using its foreign currency reserves to buy massive quantities of Canadian dollars. This, in turn, reduces the supply available and should stabilize the dollar’s price.
It is important to note that, in some cases, individual governments and central banks simply do not have the financial reserves necessary to cope with drastic fluctuations in the value of their currencies. As a result, central banks will often work closely with one another when such interventions become necessary. This may include lending money to one another, or coordinating interventions in the currency markets in order to stabilize a vulnerable currency.
Manipulating Interest Rates
Another important factor is the level of interest rates in Canada. Interest rates constitute the amount lenders charge individuals and businesses to borrow money. Suppose the interest rate in Canada is higher than in the United States (particularly after each country’s rate of inflation is taken into account). This means that lenders can get a higher rate of return for lending in Canada than in the United States. In order to take advantage of this higher rate of return, international investors will shift their portfolios (for example, government bonds) from the United States to Canada.
These sorts of shifts cause an increase in demand for Canadian dollars. In order to buy Canadian government bonds, investors first have to purchase Canadian dollars; the result is an increase in the demand for Canadian currency. Meanwhile, the demand for the US currency would fall as investors divest themselves of US government bonds in order to reinvest that money in Canada, where they can gain a higher rate of return. The overall result: a rise in the value of the Canadian currency relative to its US counterpart.
As such, the Bank of Canada can attempt to influence Canadian dollar exchange rates by manipulating the interest rates. If the Bank wishes to stop or slow a drop in the value of the Canadian dollar, it may raise interest rates to levels higher than in other nations; this, in turn can spur investment in Canada relative to other nations and demand for the dollar. Conversely, if the Bank wishes to stop or slow a rise in the value of the dollar, it can do so by lowering interest rates below other countries, thus causing lower relative investment and demand for the dollar.
It is, however, important to note that manipulation of interest rates for monetary policy is a very complex task. For example, while higher interest rates may spur higher demand for the Canadian dollar amongst lenders, it can also reduce demand amongst other economic actors. As explained earlier, the value of the dollar depends in large part on the level of business activity and foreign investment. High domestic interest rates often have the result of slowing down general economic activity and investment, as businesses and consumers cannot cheaply borrow the money they need to continue or expand their operations or make consumer purchases. This economic slowdown can, in turn, reduce domestic and international demand for Canadian dollars.
Controlling Inflation Rates
Another important tool in monetary policy is controlling inflation rates. Inflation is the rate at which prices for goods and services rise over time. For example, in the 1950s, a bottle of soda pop cost Canadians a dime, while today that same bottle costs nearly two dollars. This increase in price over time (inflation) represents a long-term erosion of the purchasing power of the Canadian dollar; whereas one Canadian dollar used to be able to purchase 10 bottles of pop, now it can only purchase half a bottle.
While every modern economy experiences a certain level of inflation, businesses and investors generally prefer an economy with low and stable levels of inflation. Not only does this protect their investments from eroding substantially in value, it also allows for long-term business planning and investing. With low and stable levels of inflation, businesses can predict what their production costs (for equipment, technology, and labour) will be over the long-term. This, in turn, makes those investments safer and encourages companies and individuals to do business in the economy.
It is at this point that we can see the importance of inflation and the value of the Canadian dollar. If inflation in Canada is higher than in other countries, domestic and foreign investors will prefer to do business in other nations. This, in turn, causes lower demand for the Canadian dollar and a downward pressure on its value in international currency markets. The exact opposite is true if inflation in Canada is low relative to other countries; low inflation will spur the flow of investment dollars into Canada, increase demand for the Canadian dollar, and place an upward pressure on its value.In order to control inflation, the Bank of Canada actively pursues inflation targets, and does so by manipulating interest rates (or the cost of borrowing) and consumers' spending habits. Take, for example, a situation in which inflation is rising at high levels (meaning that prices for goods and services are increasing substantially each year). To combat such increases, the Bank of Canada will raise interest rates. These higher rates will lead to lower consumer demand in the economy, as it becomes much more expensive to borrow in order to purchase goods and services. Lower consumer demand should, in turn, cause prices to stabilize over time, thus bringing inflation under control.
The housing market is a useful illustration of this. Higher interest rates mean that home mortgages become more expensive. This leads to lower demand in the housing market, as many buyers cannot afford the higher mortgage payments. With fewer home buyers, the housing market usually ‘cools down,’ meaning that home prices stabilize or even fall.
Ensuring Political Stability
While not a part of monetary policy, another important method of influencing the value of the Canadian dollar is by ensuring political stability. Investors generally prefer economies that are very stable politically, as this allows for long-term business planning and investing. If a nation becomes politically unstable, domestic and international businesses tend to become more cautious in their investments. This, in turn, can reduce demand for Canadian dollars and lower its value in international currency markets.
Changes in the Value of the Canadian Dollar: Consequences
Economic, social and political impacts of Canadian exchange rates
Exchange rates are economically, socially, and politically relevant. This section examines some of the consequences of changes in a nation’s exchange rate.
International Trade & the Economy
Almost every country in the world engages in trade with one another; countries import goods and services from other nations, as well as export their own domestic products. Exchange rates have an important role in this process. When Canadians import goods and services from the United States, for example, they usually do so in American currency. Canadian importers must first exchange their Canadian dollars for American funds, and then use those funds to buy American products. The same is also true with regard to Canadian exports: when buying Canadian goods and services, foreign consumers must first exchange their currencies for Canadian dollars.
Changes in exchange rates, therefore, can causes changes in the price of Canada’s imports and exports. If, for example, Canada’s currency significantly increases in value relative to the currencies of its trading partners, then importing foreign goods and services becomes much cheaper. Canadians gets a bigger “bang for their buck” when exchanging their Canadian dollars and purchasing foreign products. At the same time, however, Canadian exports also become more expensive for other countries to purchase, as foreign importers must exchange more of their currencies in order to buy Canadian products. The exact opposite effect can occur when Canada’s currency drops significantly in value relative to its trading partners. Foreign imports become more expensive, while the nation’s exports become cheaper for other nations to buy.
These changes in exchange rates and import/export costs can have significant consequences for Canada’s economy. When the Canadian dollar rises in value, Canadian producers are often faced with stiffer foreign competition at home, as the cost of foreign imports becomes cheaper. A higher Canadian dollar also means Canadian exporters must deal with higher prices for their products abroad, with the possibility that foreign consumers may look elsewhere for cheaper prices. There are, however, some benefits to a higher Canadian dollar. Many Canadian producers depend on foreign imports when producing their goods or services (such as raw materials, machinery, or technology). A higher Canadian dollar means lower production costs and greater competitiveness for these Canadian producers.
Again, the exact opposite effect can occur when the Canadian dollar drops in value. A lower Canadian dollar means less competition for Canadian producers at home, as foreign imports come more expensive for Canadians to purchase. Canadian producers that depend on foreign imports when producing their goods and services, however, face higher production costs. Finally, Canadian exporters gain a price advantage internationally, as their products become cheaper for foreign consumers to purchase.
It is important to note, however, that recent improvements in technology and international transportation have made it possible for modern economies, including Canada’s, to reduce the risks of currency fluctuations. Many North American companies, for example, have developed networks of domestic and international suppliers for many components of their products, or stages of their production processes. Factors such as the rising “import content” of Canadian exports and “just-in-time” inventory management systems have allowed many Canadian producers to withstand the drastic increase in value of the Canadian currency relative to the US dollar that took place in the late 1990s and early 2000s — something that might have put them out of business in an earlier era.
International Trade & the Cost of Living
The relationship between exchange rates and international trade impacts not only Canadian producers, but also Canadian consumers; in particular, the cost of living for consumers (or the average cost of basic goods and services, such as food, shelter, and clothing). Canadians today depend on many foreign imports for their basic needs, be it agricultural products, building supplies, manufactured garments, and so forth. Changes in Canadian exchange rates can make these foreign goods and services more or less expensive to import, which, in turn, influences how much Canadians must pay to cover their basic needs.
For example, during the winter months, Canadians usually depend on fruits and vegetables imported from the southern United States. If the Canadian dollar decreases in value relative to the US dollar, then Canadians are forced to pay more in their domestic currency to purchase these basic goods imported from the US. As a result, the daily food cost for Canadians rises and they experience an upward pressure on their cost of living.
These sorts of changes can have important social impacts, especially for low-income or fixed-income earners. Drastic increases in the cost of living means that persons have less purchasing power to pay for imported goods and services they depend upon. For those close to the poverty level, this can have dire consequences. Conversely, a rise in the value of the Canadian dollar means cheaper foreign imports, and a decrease in the cost of living. As a result, persons have a greater financial capacity to buy their basic goods and services.
International Tourism & Travel
Another area where exchange rates have an impact is international travel and tourism. A fall in the Canadian dollar, for example, has the dual effect of making international travel for Canadians more expensive, while making vacationing in Canada for foreign tourists cheaper. Such a situation can spur Canada’s tourism industry, as more Canadians vacation at home instead of abroad, and as more foreign tourists come to Canada to take advantage of the cheaper exchange rate.
A rise in the value of the Canadian dollar, however, can have a negative impact on the tourism industry. Such a rise means that foreign tourists must pay more than before to vacation in Canada, with the possibility that they may look elsewhere for cheaper vacations. Moreover, a higher Canadian dollar means that it is cheaper for Canadians to travel abroad, making it easier for them to take vacations outside of the country.
Exchange Rates & Foreign Debt
Exchange rates also can have an important impact on government finances. Canadian territorial, provincial and federal governments, like most governments in the world, have some level of foreign debt — that is, debt they owe to foreign financial institutions or governments. In many cases, this foreign debt is held in a foreign currency (be it that of the lender or of a major foreign currency, such as the United States or the European Union’s). As such, changes in exchange rates can have considerable implications for the costs associated with maintaining and paying back this foreign debt.
In this context, let’s look at another example. Say, for instance, the Canadian federal government borrows $1 billion in American currency from a US bank when the Canadian dollar is valued at US $0.90 (meaning one Canadian dollar is worth 0.90 American dollars, or 90 cents). The cost of paying back that loan (without interest) would be around $1.1 billion in Canadian currency. If, however, the value of the Canadian dollar was to drop to US $0.62 (so that one Canadian dollar equaled only 62 American cents), then the cost of paying back that same loan in Canadian currency would climb to CAN $1.6 billion, an increase of $500 million Canadian dollars. The exact opposite holds true when the dollar increases; loans taken out at a lower exchange rate become much cheaper to maintain and pay back as the currency value rises in relation to the lender’s currency.
These sorts of changes can have further political and social impacts. If the value of a nation’s currency were to fall, and the cost of maintaining loans (held in foreign currency) were to rise substantially, then governments must find ways to compensate. This may mean increasing taxes, reducing social spending, or running a deficit. The opposite is true if the currency rises; with lower loan costs, additional funds are available for cutting taxes or investing in social programs.
Sources & Links to Further Information
List of Article Sources & Links for More on the Council & Federalism
Sources Used for this Article
- “The Exchange Rate.” Bank of Canada. 20 July 2006.
- “Inflation and Price Stability.” Bank of Canada. 20 July 2006.
- “Inflation Control Target.” Bank of Canada. 20 July 2006.
- “Interest Rates.” Bank of Canada. 20 July 2006.
- “Monetary Policy.” Bank of Canada. 20 July 2006.
- “The Foreign Exchange Market in the United States.” Federal Reserve Bank of New York. 20 July 2006.
- Powell, J. “A History of the Canadian Dollar.” Bank of Canada. 20 July 2006.
Links for Further Information
- The Fall & Rise of the Canadian Dollar: Causes & Consequences
- The Bank of Canada
- Bank of Canada: Brief History of the Canadian Dollar
- Bank of Canada: Monetary Policy
- Bank of Canada: History of the Canadian Dollar