Monetary Policy

The Canadian Dollar: Nature and Impacts of Canadian Exchange Rates

Jay Makarenko — Thu, 01 Feb 2007 00:00:00 -0700

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.

Valuing the Canadian Dollar Relative to Other Currencies

Exchange rates and the modern floating exchange system

Market Influences on the Canadian Dollar

The dynamics of supply and demand relating to the Canadian Dollar

Government Influences on the Canadian Dollar

Monetary policy and government intervention

Changes in the Value of the Canadian Dollar: Consequences

Economic, social and political impacts of Canadian exchange rates

Sources & Links to Further Information

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:

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:

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 Dollar

The 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 Dollar

Monetary 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

Electronic Sources

“The Exchange Rate.” Bank of Canada. 20 July 2006.
<http://www.bankofcanada.ca/en/backgrounders/bg-e1.html>
“Inflation and Price Stability.” Bank of Canada. 20 July 2006.
<http://www.bankofcanada.ca/en/backgrounders/bg-i1.html>
“Inflation Control Target.” Bank of Canada. 20 July 2006.
<http://www.bankofcanada.ca/en/backgrounders/bg-i3.html>
“Interest Rates.” Bank of Canada. 20 July 2006.
<http://www.bankofcanada.ca/en/backgrounders/bg-p6.html>
“Monetary Policy.” Bank of Canada. 20 July 2006.
<http://www.bankofcanada.ca/en/backgrounders/bg-p1.html>
“The Foreign Exchange Market in the United States.” Federal Reserve Bank of New York. 20 July 2006.
<http://www.ny.frb.org/education/addpub/usfxm/>
Powell, J. “A History of the Canadian Dollar.” Bank of Canada. 20 July 2006.
<http://www.bankofcanada.ca/en/dollar_book/index.html>

Links for Further Information

Mapleleafweb Links

The Fall & Rise of the Canadian Dollar: Causes & Consequences
The Bank of Canada

Government Links

The Bank of Canada

Rhonda Parkinson — Tue, 01 Oct 2002 00:00:00 -0600

The Bank of Canada (BOC) is a central economic and financial institution in Canadian government and politics. It oversees such important things as the national borrowing rates (interest rates), as well as the value of the Canadian dollar relative to other national currencies. This article introduces the Bank of Canada as an economic and political institution; in particular, it discusses the Bank's roles and powers, its structure and modes of operation, as well as some of the issues and debates surrounding the Bank.

Understanding the Bank of Canada

How the Bank of Canada operates

History of the Bank of Canada

Why did Canada need a central bank?

The Bank of Canada’s Role in Managing the Economy

A look at the Bank’s monetary policy throughout the decades

Profiles of Current and Past Governors of the Bank of Canada

Profiles of the Bank's Governors

Assessing the Bank of Canada

Criticisms and proposals for reform

Links for More Information

List of links for more on this topic

Understanding the Bank of Canada

How the Bank of Canada Operates

The policies implemented by the Bank of Canada have a major impact on the Canadian economy. To fully understand the Bank of Canada, it is necessary to examine how it operates and its relationship with the federal Finance Department.

What is the Role of the Bank of Canada?

According to the preamble in the Bank of Canada Act, the Bank's mandate is to:

Regulate credit and currency
Control and protect the external value of the national monetary unit
Use monetary action to mitigate fluctuations in the general level of production, trade prices, and employment.

The Bank administers the nation’s currency, protects its value, and acts as the government's and chartered banks' official banker. The Bank of Canada's most important function is to set monetary policies that will promote a healthy economy. This is accomplished primarily through taking steps to raise and lower interest rates.

How Does the Bank of Canada influence interest rates?

The key mechanism by which the BOC influences interest rates (or the cost of borrowing money) is through the setting of short-term rates. The BOC tells banks the average interest rate it wants to see on loans over a specified period of time. Since 1996, the BOC has used the overnight rate target, or the rate at which money is loaned to institutions overnight, to set monetary policy. A change in the overnight rate usually leads to a change in the prime interest rate.

The Bank of Canada's Internal and External Structures

Internal Structures

The Bank of Canada is headed by:

The Governor of the Bank of Canada, who serves as its Chief Executive Officer. The Governor is appointed for a seven-year period and can be reappointed.
A Governing Council consisting of the Governor, the Senior Deputy Governor, and four deputy governors.
A Board of Directors consisting of the Governor, the Senior Deputy Governor, and 12 “outside” directors appointed from across Canada. The 12 directors are appointed for a three-year period and can be reappointed. Their terms overlap. The Governor is the Chairman of the Board.

The balance of power flows from top to bottom. Ultimate authority resides with the Governor. The directors are expected to provide a perspective on economic conditions in their region. The Governing Council can take these perspectives into consideration when creating monetary policy, but it is not obligated to do so.

The Board of Directors is responsible for financial and administrative organization within the Bank, but the Governing Council maintains ultimate authority over these areas. The Board has no say in the formulation of monetary policy.

External Structures

The Bank’s mandate to "regulate and protect the national currency" means it plays a role in external organizations outside the main bank structure:

Canadian Payments Association: Created in 1980, the Canadian Payments Association is Canada’s system for handling the transfers of funds between banks. The Bank of Canada does not own the Canadian Payments Association, but an officer of the Bank is Chairperson of the CPA’s Board of Directors.
Business Development Bank of Canada: Formerly known as the Industrial Development Bank, the Business Development Bank (BDC) was created to stimulate investment in smaller manufacturing industries. Originally a subsidiary of the BOC, it now exists more independently; the Governor of the BOC is no longer the President. Over time, the BDC’s mandate changed to allow it to provide many services to small- and medium-sized businesses.
Canadian Deposit Insurance Corporation: The CDIC is a federal Crown Corporation that was created in 1967 to provide deposit insurance to investors. The Governor of the Bank of Canada sits on the CDIC’s Board of Directors.

The Bank of Canada’s Relationship with the Federal Department of Finance

The Bank of Canada’s relationship with the government consists of both formal and informal mechanisms:

Formal

The outside Board of Directors appoints the Bank Governor and the Senior Deputy Governor, with the government's approval.
The Finance Minister appoints a new director or reappoints a director when his/her term of office expires.
The Deputy Finance Minister sits on the Governing Council and the Board of Directors, but does not vote.
The Bank of Canada submits an annual report to the Department of Finance. The Governor must be available for questioning on the report by the House of Commons Standing Committee on Finance.

Informal

The Bank of Canada Act instructs the Governor to “consult regularly on monetary policy and on its relation to general monetary policy.” In practice this means that the Governor of the Bank meets weekly with the Finance Minister.

History of the Bank of Canada

Why did Canada need a central bank?

To understand the Bank of Canada, it helps to understand the conditions that led to the creation of a central banking system. Here is a brief history of banking in Canada before and after the creation of the Bank of Canada.

Early Years of Banking in Canada

In 1817, the Bank of Montreal opened its doors, becoming Canada’s first bank. By the time of Confederation in 1867 there were 28 banks operating in Canada. The 1867 Constitution Act gave the new Dominion government control over banking and currency. Further, the establishment of the Canadian Bankers Association in 1891 gave banks a formal structure to communicate with the Dominion (national) government. The Bank Act of 1900 made membership in the Canadian Bankers Association compulsory.

During the 1800s, a combination of factors made it unnecessary to establish a central bank in Canada. Prior to Confederation, fewer banks were established in Canada than the United States, as the close relationship between business elites and government officials in Upper and Lower Canada made it more difficult for outsiders to obtain a bank charter. In addition, Canada’s smaller population and the prevalence of seasonally based industries such as agriculture and fishing made it more difficult for independent banks to operate. Instead, banks turned to branch banking to meet the financial needs of rural populations.

Branch banking expanded following Confederation, as banks obtained federal charters and established branches across Canada. During this period, several smaller independent banks, such as Newfoundland’s Union Bank, closed or were absorbed by the larger banks.

The development of fewer, larger banks, such as the Bank of Montreal, meant that the federal government did not have to establish a central bank to handle its financial business. Furthermore, the banks developed their own system for clearing cheques, removing the need for a central bank to do so.

The Need for a Central Bank

Although several proposals for a central banking system were put forth in the early 1900s, the federal government showed little interest. Prime Minister R.B. Bennett was the first Prime Minister to see the advantages of a central banking system. In 1931, he gave a speech announcing that Canada needed to have direct control over its monetary policy. He believed Canada should be able to independently settle its international accounts without having to go to Wall Street.

Meanwhile, the effects of the Depression of the early 1930s led people to criticize the way banks were run. Moreover, actions taken by the banks during this period helped produce a harmful deflation, in which a reduction in spending led to a fall in prices, which led to further spending reductions. These factors helped increase the momentum for a central bank in Canada.

In 1933, the government appointed a Royal Commission headed by Britain’s Lord Macmillan to examine the pros and cons of establishing a central banking system. In September 1933, after holding public hearings across the country, the Royal Commission released a report recommending the creation of a central bank, along with a draft constitution of its main features.

The Legislative Debates

A large portion of the legislative debates focused on the issue of private versus public ownership. At the heart of the issue was the nature of the BOC’s relationship with the federal government. Legislators were concerned that the BOC remain free from political interference, while at the same time remaining responsive to the financial and economic priorities set out by the federal Finance Department. The issue of BOC independence is still a hot topic today.

In February 1934, the federal government introduced legislation for the creation of a central bank. The bill closely followed the draft recommendations contained in the Macmillan Report; however, it gave greater emphasis to the central bank's role in domestic economic policy than existed in the Macmillan Report. The Bank of Canada Act received Royal Assent in July 1934. In March 1935, the Bank of Canada opened under private ownership, headed by a Governor appointed for a period of seven years. The Bank Act was amended in 1938 to make it a publicly owned institution.

The Bank of Canada’s Role in Managing the Economy

A look at the Bank ’s monetary policy throughout the decades

The Bank of Canada's objectives and goals have undergone major changes since it was created in 1935. Here is an outline of pivotal shifts in the Bank of Canada’s monetary policy since its inception.

The War Years

Within days of declaring war on Germany, Canada introduced foreign exchange controls to protect the flow of foreign currency out of the country. In September 1939, a Government Order in Council established the Foreign Exchange Control Board. The Governor of the Bank of Canada was Chairman of the Board of Directors. The Bank of Canada helped finance the war effort by overseeing the sale of victory bonds and extending cash advances to the government.

The Post-War Years

In the years following World War II, the BOC’s focus switched from aiding the war effort to stimulating employment. In 1944, a subsidiary of the Bank of Canada, the Industrial Development Bank (IDB), was created to stimulate investment in small- to medium-sized manufacturing industries. The Governor of the Bank of Canada was also the President of the Industrial Development Bank.

Throughout this period, the Bank Of Canada’s monetary policy was designed to keep interest rates down. Although employment rates rose, critics argued the BOC was not doing enough to combat inflation.

The 1950s to 1960s

In the 1950s, inflationary pressures forced the Bank Of Canada to take a more active role in setting monetary policy. Initially, the BOC imposed controls on certain types of bank financing. This failed to stop pressure on the Canadian dollar, caused by factors such as high amounts of American investment capital and rising world commodity prices. In October 1950, the BOC decided to float the Canadian dollar. In doing so, Canada abandoned an agreement by all International Monetary Fund (IMF) countries to peg the value of their currencies to the American dollar. Floating the dollar made it easier for the Bank to impact the domestic economy through its monetary policy. The BOC expected this to be a temporary measure.

As inflation rates continued rising, the BOC adopted a policy of monetary restraint. In 1954, the BOC took steps to raise interest rates and reduce the supply of cash reserves to the chartered banks. This policy continued until the early 1960s, when the BOC found itself at odds with the expansionist policies of the Diefenbaker government.

1960s

In the early 1960s, the Bank of Canada continued with a policy of monetary restraint to keep inflation rates low. Critics blamed the Bank's monetary policy for reduced economic activity and a rising unemployment rate. In 1962, the Bank of Canada and the government returned to the Bretton Woods system, pegging the Canadian dollar at US $0.925. Throughout the remainder of the decade, the Bank's monetary policy tried to achieve a trade-off between achieving price stability and maintaining a healthy economy. It permitted a certain level of inflation to keep employment levels steady. The fixed exchange rate limited the Bank of Canada's ability to cope with the inflationary pressures that increased throughout the 1960s.

1970s

In the early 1970s, inflationary pressures caused by unforeseen international events — such as the oil shock of 1973, blamed on the OPEC oil cartel — forced the BOC to return to a more independent monetary policy. In 1971, the BOC decided once again to float the Canadian dollar, to deal with pressures on the dollar caused by an influx of foreign capital. In 1975, the Bank of Canada adopted a policy of monetary gradualism to cope with “stagflation” — a combination of rising inflation and high unemployment. The BOC gradually lowered the rate of money growth, setting it just high enough to meet the needs of the economy. In late 1975, the Anti Inflation Board introduced Wage and Price Controls.

1980s

In 1982, the Bank of Canada abandoned the policy of monetary gradualism. Until 1988, the Bank of Canada operated without a specific target for monetary policy. The lack of a clearly defined monetary policy heightened the effects of external factors, such as a shift in US interest rates, on the Canadian economy. In 1988, the Governor of the Bank of Canada announced that price stability would be the Bank of Canada's new objective in formulating monetary policy.

1990s-Today

In 1991, the Bank Of Canada introduced inflation-reduction targets as a means of achieving price stability. The BOC hoped that setting specific targets would stabilize the economy, since the long-term goal of monetary policy would be clearer. Originally, the targets were set at two and four percent annually, with a midpoint of three percent. In 1995, revised targets were set at one and three percent, with a midpoint of two percent.

Today, price stability remains the BOC’s primary monetary policy. In 1996, the Bank Of Canada switched to the Overnight Target Rate as the key factor in determining interest rates. In 2001, the BOC changed its definition of how the Consumer Price Index (the main measure of inflation) was calculated, to minimize the impact of volatile price swings in goods such as gasoline.

Profiles of Current and Past Bank of Canada Governors

Profiles of the current and past Governors of the Bank of Canada

Graham Towers

Graham Towers was Governor of the Bank of Canada from 1934 to 1954. In 1920, Towers left law studies at McGill University to become Superintendent of the Foreign Trade Department at the Royal Bank of Canada. He left RBC in 1934 to become the Bank of Canada's first governor. During his tenure, Towers introduced wage and price controls during World War II to control inflation. In 1950, he reacted to inflationary pressures by deciding to float the Canadian dollar, effectively abandoning the Bretton Woods Agreement.

James Coyne

James Coyne served as Governor of the Bank of Canada from 1955 to 1961. Coyne attended Oxford University as a Rhodes Scholar, then in 1938 he joined the Bank of Canada's research department. He served in World War II, then rejoined the Bank in 1944. Coyne served as Deputy Governor from 1950 to 1954. During his time as Governor, Coyne pursued a monetary policy designed to lower inflation despite opposition from the Diefenbaker government (expressed through Diefenbaker's Minister of Finance). The federal government tried, unsuccessfully, to fire him since only Parliament and not the executive can terminate the Bank of Canada's Governor. Coyne subsequently resigned in 1961. The political fallout from this incident is considered to be one of the reasons why Diefenbaker's Conservatives were defeated in the 1963 election.

Louis Rasminsky

Louis Rasminsky was the Bank of Canada's Governor from 1961 to 1973. Rasminsky completed post-graduate work at the London School of Economics, and in 1930 joined the League of Nations as a specialist in monetary and banking matters. In 1940, he joined the Bank Of Canada’s Foreign Exchange Control Board. As Board Chairman, Rasminsky played a leading role in establishing a compromise between the US and British positions in discussions leading to the Bretton Woods Agreement. Rasminsky served as Deputy Governor of the BOC from 1955 to 1961.

After becoming BOC Governor, Raminsky insisted that the government should clarify the roles of both the Bank Of Canada and the Finance Department in setting monetary policy. He recommended returning to a pegged exchange rate for the Canadian dollar due to the fallout from the Coyne affair. A pegged exchange rate combined with increased government spending made it difficult for the Governor to implement monetary policies that would combat inflation effectively.

Gerald Bouey

Gerald Bouey served as Governor from 1973 to 1987. Bouey received an Honours BA in Economics from Queen's University. He joined the Bank of Canada's research department in 1948 and subsequently served as Deputy Governor from 1969 to 1972, then as Senior Deputy Governor from 1972 to 1973. While serving as BOC's Governor, Bouey fought inflation by pursuing a policy of “monetary gradualism,” supported by wage and price controls. Interest rates rose dramatically under this policy, reaching 20 percent at one point. Inflation continued to rise, reaching almost 11 percent in 1987. The government continued to support the Bank of Canada despite rising unemployment and widespread criticism of the impact the BOC's monetary policy was having on different sectors of the economy. Bouey resigned in 1987 after serving two terms as Governor.

John Crow

John Crow served as BOC Governor for one term, from 1987 to 1994. After graduating from Oxford University, Crow joined the International Monetary Fund (IMF); he covered Latin America where he saw firsthand the effects of runaway inflation. Crow joined the Bank of Canada's research department in 1973. Between 1981 and 1987, he served as Deputy Governor and Senior Deputy Governor. During his tenure as Governor Crow fought inflation through a monetary policy of price stability; zero inflation was the ultimate goal of price stability. Crow also introduced inflation reduction targets. Under this policy, unemployment rates rose to over 10 percent by the 1993 federal election. Crow was highly criticized for producing a "Made in Canada" recession. Further, critics argued that Crow's policies violated the Bank of Canada's mandate. In the spring of 1994, the federal Liberal government refused to renew Crow's appointment.

Gordon Thiessen

Gordon Thiessen spent one term as BOC Governor from 1994 to 2001. In 1963, Thiessen joined the Bank of Canada's research department after receiving an MA from the University of Saskatchewan. In 1972, he received a Ph.D. in economics from the London School of Economics. Between 1973 and 1975, Thiessen was a visiting economist at the Reserve Bank of Australia. Between 1984 and 1994 he served as Deputy Governor and Senior Deputy Governor. As Governor Thiessen kept the inflation reduction targets of 1 to 3 percent previously announced by Crow, but abandoned the goal of zero inflation. He changed the phrase “inflation reduction target” to the less controversial “inflation control target.” Thiessen also introduced a number of initiatives to explain the Bank of Canada's monetary policy to the general public.

David Dodge

As of June 2007, David Dodge is the Bank of Canada's Governor, a position he assumed in 2001. Dodge earned his Ph.D. in economics from Princeton University and was an assistant professor in economics at Queen's University. Highlights of his civil service career include positions with the Central Mortgage and Housing Corporation and the Department of Employment and Immigration. He became Canada's Deputy Minister of Finance in 1992, a position he held until 1997. Dodge is the only BOC Governor who did not serve as a Deputy Governor with the Bank of Canada. In his first year in office, Dodge began cutting interest rates to stimulate the economy. He also faced a tough challenge after the 9/11 attacks rattled financial markets around the world and threatened to stunt economic growth. Dodge responded with a series of dramatic interest rate cuts, reducing the Bank's key rate to 40-year lows. He also extended the inflation control target of 1-3 percent. Dodge's first term as Governor ends in 2008; he has already informed the federal government of his plan to retire and not seek a second term.

Assessing the Bank of Canada

Criticisms and proposals for reforming the Bank of Canada

Since its creation in 1935, the Bank Of Canada has struggled to keep free from undue political interference, while remaining receptive and responsive to government economic policy. The difficulty in reconciling these two, often opposing, goals has left the Bank open to criticism on several fronts.

Formal Structure

Structural criticisms centre primarily on the BOC’s mandate, and the structure of its governing bodies.

The Bank of Canada's Mandate

The Bank of Canada's mandate is to “regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of trade, prices, and employment, so far as may be possible within the scope of monetary action, and generally to promote the economic and financial welfare of Canada.”

This is a broad mandate, giving the BOC a greater role in domestic economic policy than was originally proposed by the Macmillan commission. Critics argue that it is both too ambitious and too ambiguous. One proposal suggests limiting the BOC’s mandate to a clearly defined monetary policy, such as achieving domestic price stability. Others have pointed out that this would be difficult, since the BOC’s monetary policy has changed over time. While price stability has always been one of the goals, originally it was not the main goal.

Another argument in favour of the original mandate is that it provides some protection against extreme shifts in monetary policy. It is the Bank Of Canada’s role in protecting against fluctuations in employment that led to accusations that Governor Crow overstepped the mandate when he set a goal of zero inflation.

The Structure of the Governing Bodies

The two main areas of criticism are the power of the Governor, and the lack of regional input into monetary policy:

Powers of the Governor

Critics oppose the concentration of power in one individual, the Governor, who serves as the BOC's Chief Executive Officer and Chairman of the Board of Directors. In 1994, a governing council was created in an attempt to decentralize power. However, the Governor sits on the Council and maintains the final authority over policy. The Finance Minister meets weekly with the Governor, not the entire Governing Council.

Lack of Regional Representation

The Bank of Canada's commitment to regional representation is limited to the 12 "outside" directors who sit on the Bank of Canada Board of Directors. The Governing Council maintains final authority over the Board of Directors. The outside directors are expected to provide a perspective on economic conditions in their region; however, the Governing Council is not obliged to act on these perspectives. The Bank of Canada has been criticized for implementing monetary policies that are more responsive to the needs of central Canada, particularly Ontario, over other regions of the country.

Relationship with the Government

Some critics have argued that the Bank Of Canada is too independent from the government, while others have argued that is not independent enough. The issue of BOC independence is closely intertwined with the contentious issue of the Governor's power.

Past and Proposed Reforms to the Bank of Canada

Previous Reforms

In 1967, the Liberal Government revised the Bank of Canada Act to permit the Finance Minister to override BOC monetary policy in the case of a disagreement between the BOC Governor and the government. However, it would be difficult for the government to use this veto in practice because of the potential negative backlash from the international financial community. The ambiguity of the Bank Of Canada's mandate makes it difficult to justify using the override. In 1994, the Governing Council was created in an attempt to spread decision-making power to more than one individual.

Proposed Reforms

Economists and political scientists have put forth several interesting proposals for reforming the Bank Of Canada's structure. For example:

Place responsibility for monetary policy in the hands of a regionally representative council, providing equal representation to all the regions;
Allow provincial governments to nominate candidates for the council; and
Give the federal government power to reject any candidate.

During the 1991 Constitutional talks, the federal government released a position paper that proposed the following changes to the Bank of Canada Act:

Amend the mandate to clearly state that the Bank’s role is to achieve and maintain price stability;
Require the federal government to consult with provincial governments before making appointments to the BOC's Board of Directors;
Keep BOC Directors informed on economic regions in their area through the creation of regional consultative panels; and
Make the appointment of the Governor of the BOC subject to Senate ratification (from Shaping Canada’s Future Together: Proposals).

Changes to the Bank of Canada Act were dropped from subsequent constitutional talks.

Social Costs of the Bank of Canada Policies

The Bank Of Canada remained relatively free from public scrutiny until the early 1980s (and again in the early 1990s), when it began aggressively fighting inflation. Such BOC initatives involved increasing interest rates (the cost of borrowing) in order to slow the economy. Critics have argued, however, that such such BOC actions have a negative impact on large segments of society. Consumers and businesses have to pay more to borrow money, which can slow or even decline the economy. This, in turn, negatively affects the workers who may lose their jobs or face wage reductions as a result, as well as young persons attempting to enter the workforce for the first time.

Links for More Information

List of links for more on this topic

Monetary Policy

The Canadian Dollar: Nature and Impacts of Canadian Exchange Rates

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

What are Exchange Rates?

Early Exchange Systems: Gold Standard & Bretton Woods

Current Exchange System: Currency Markets & Floating Rates

Market Influences on the Canadian Dollar

Business Activity in the Canadian Economy

Movement of International Investment

Speculative Trading & the Canadian Dollar

Government Influences on the Canadian Dollar

What is Monetary Policy?

Bank of Canada & Monetary Policy

Regulating the Money Supply

Manipulating Interest Rates

Controlling Inflation Rates

Ensuring Political Stability

Changes in the Value of the Canadian Dollar: Consequences

International Trade & the Economy

International Trade & the Cost of Living

International Tourism & Travel

Exchange Rates & Foreign Debt

Sources & Links to Further Information

Sources Used for this Article

Electronic Sources

Links for Further Information

Mapleleafweb Links

Government Links

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The Bank of Canada

How the Bank of Canada operates

Why did Canada need a central bank?

A look at the Bank’s monetary policy throughout the decades

Profiles of the Bank's Governors

Criticisms and proposals for reform

List of links for more on this topic

Understanding the Bank of Canada

What is the Role of the Bank of Canada?

How Does the Bank of Canada influence interest rates?

The Bank of Canada's Internal and External Structures

Internal Structures

External Structures

The Bank of Canada’s Relationship with the Federal Department of Finance

Formal

Informal

History of the Bank of Canada

Early Years of Banking in Canada

The Need for a Central Bank

The Legislative Debates

The Bank of Canada’s Role in Managing the Economy

The War Years

The Post-War Years

The 1950s to 1960s

1960s

1970s

1980s

1990s-Today

Profiles of Current and Past Bank of Canada Governors

Graham Towers

James Coyne

Louis Rasminsky

Gerald Bouey

John Crow

Gordon Thiessen

David Dodge

Assessing the Bank of Canada

Formal Structure

The Bank of Canada's Mandate

The Structure of the Governing Bodies

Powers of the Governor

Lack of Regional Representation

Relationship with the Government

Past and Proposed Reforms to the Bank of Canada

Previous Reforms

Proposed Reforms