The Canadian Dollar: What Determines the Exchange Rate?

(Disponible en français : Le dollar canadien : les facteurs qui influent sur le taux de change)

From the beginning of World War II until 1950, and again from 1962 to 1970, the value of the Canadian dollar was fixed in relation to the U.S. dollar. The Bank of Canada was responsible for intervening in the marketplace to maintain the fixed value of the currency.

Now, the exchange rate between the Canadian dollar and any foreign currency is determined by the forces of supply and demand, that is, like the value of any other openly traded good or service. Factors that increase (or decrease) demand for the Canadian dollar, or that decrease (or increase) demand for foreign currency, place upward (or downward) pressure on the exchange rate.

Factors Affecting the Value of the Canadian Dollar

Economic theory and empirical evidence have identified factors that, in isolation from one another, have predictable effects on exchange rates. However, predicting exchange rate movements is difficult because these factors interact at the same time. Often, the reasons underlying recent movements are evident only in hindsight.

The main factors known to influence the value of the Canadian dollar are:

  • Interest rates: Relatively higher interest rates in Canada increase foreign investors’ demand for Canadian dollar-denominated securities. However, the rate of return of foreign investors is dependent on the expected future performance of the Canadian dollar. If foreign investors anticipate a decline in the value of the Canadian dollar, they demand a higher interest rate on Canadian dollar securities.
  • Commodity prices: The value of the Canadian dollar is correlated to the strength of world commodity prices. Commodities represent a larger share of exports in Canada compared to the United States and many other countries. When commodity prices rise, Canada’s terms of trade improve because its goods have become relatively more valuable. Since Canada’s effective purchasing power is higher, this movement is usually reflected in a higher exchange rate. The opposite also holds: weaker commodity prices can translate into a weaker Canadian dollar.
  • Inflation rates: Inflation is the rate at which general price levels rise over time. If inflation in Canada were to exceed foreign inflation rates, this would reduce the purchasing power of the Canadian dollar relative to foreign currencies. That reduction would be reflected in a relative decline in the value of the Canadian dollar. The opposite is also true. Sustained, relatively low inflation in Canada has a positive influence on the exchange rate.
  • International trade of goods and services: When a country has a trade surplus, exports exceed imports, putting upward pressure on the exchange rate (the demand for the currency exceeds the supply). When a country has a trade deficit, imports exceed exports, putting downward pressure on the exchange rate (the supply for the currency exceeds the demand).
  • Foreign investment and debt payments: Inflows of foreign investment in Canada increase the foreign demand for Canadian dollars, pushing the exchange rate up. Direct investment made by Canadians abroad has the opposite effect. Debt payments made to foreigners push the exchange rate down.
  • Productivity: A country’s productivity – the amount of output that can be produced with a given level of inputs – can be a factor in the determination of the exchange rate through its effect on relative prices and international competitiveness. For example, if productivity in Canada were to grow faster than in the United States, the prices of Canadian goods would become more competitive and, over time, Canadian output and exports would increase, leading to greater demand for Canadian dollars.

What Explains the Recent Performance of the Canadian Dollar?

From January 2002 to November 2007, the Canadian dollar increased from a low of 62 cents U.S. to 1.04 U.S. dollars due to rising energy prices and strong U.S. demand for Canadian exports.

In response to the 2007 housing market crash, in September 2007, the U.S. Federal Reserve Bank reduced its target interest rate from 5.25% to an unprecedented level of 0% to 0.25% in December 2008. As the negative impact of the related 2008 financial crisis spread to other economies, the resulting economic slowdowns and contractions triggered sharp declines in both energy prices and the U.S. trade deficit. As a result, by early 2009, most world currencies, including the Canadian dollar, had lost most of their pre-2008 gains against the U.S. dollar.

In response, the Bank of Canada lowered its target interest rate from 3% in October 2008 to a historic low of 0.25% in April 2009 and maintained it at that level until May 2010. This significantly reduced the target interest rate difference between Canada and the U.S. at a time when energy prices and Canadian exports were rebounding. These factors in turn increased the value of the Canadian dollar from 78 cents in March 2009 to 1.05 U.S. dollars in July 2011.

With a target interest rate of almost zero and the implementation of a fiscal stimulus package, the U.S. economy gradually recovered from the 2008 financial crisis. This resulted in growing productivity and employment and an inflow of investments in the U.S. Since energy prices remained relatively stable, by comparison, the Canadian dollar slowly lost its appeal and dropped below 90 cents U.S. in early 2014.

In the two following years, investors’ demand for U.S. dollar-denominated assets further increased as the U.S. economy continued to improve steadily while most other developed economies struggled to recover. The weak global demand for energy and excess supply from the expansion of oil and gas extraction techniques, particularly “fracking” in the U.S., reduced energy prices in early 2016 to their lowest levels since the early 2000s. Low energy prices, combined with the strength of U.S. dollar reduced the value of Canadian dollar to below 70 cents U.S. in January 2016.

Between January 2016 to June 2018, the slow but steady recovery in energy prices increased the value of the Canadian dollar from 70 cents U.S. to 76 cents U.S.

Author: Shaowei Pu, Library of Parliament (adapted from a publication by Michael Holden)

APPENDIX

Figure 1 – The Canada-U.S. Exchange Rate, U.S. Dollar per Canadian Dollar, 1951-2018

Figure 1 depicts the changes in Canada/U.S. dollar exchange rates between January 1951 and July 2018. It starts at 0.95 U.S. dollar in January 1951 and ends at 0.76 U.S. dollar in July 2018, with notable high points at 1.05 U.S. dollars during 1950s, 1970s and early 2010s, as well as a notable low point of 0.62 U.S. dollar in January 2002.

Note: The exchange rates are monthly averages. In 2018, only monthly data from January to July are presented.
Source: Figure prepared by the author using data obtained from Statistics Canada. Table 33-10-0163-01   Monthly average foreign exchange rates in Canadian dollars, Bank of Canada, and Table  10-10-0009-01   Foreign exchange rates in Canadian dollars, Bank of Canada, monthly, accessed 23 July 2018.

Figure 2 – Real Commodity Prices and the Canadian Dollar

Figure 2 shows the changes in energy and non-energy Commodity Price Indexes (CPI) as well as the exchange rate between U.S. dollar and Canadian dollar between January 2000 and July 2018. The energy CPI appears to be positively correlated with the exchange rate while the correlation is significantly weaker between non-energy CPI and the exchange rate.

Note: Commodity Price Index in January 2000 = 100. The exchange rates are monthly averages. In 2018, only monthly data from January to July are presented.
Source: Figure prepared by the author using data obtained from the Bank of Canada, the Bank of  Canada commodity price index (BCPI); and Statistics Canada, Table 33-10-0163-01   Monthly average foreign exchange rates in Canadian dollars, Bank of Canada, and Table 10-10-0009-01   Foreign exchange rates in Canadian dollars, Bank of Canada, monthly, accessed 23 July 2018.

Figure 3 – World Currencies’ Performance Against the U.S. Dollar, Exchange Rate Index

Figure 3 illustrates the changes in the exchange rates between the U.S. dollar and five other currencies – the Australian dollar, the Euro, the British pound, the Canadian dollar and the Japanese yen – from January 2001 to July 2018. The Australian dollar, the Euro and the Canadian dollar are the three currencies that increased the most against the U.S. dollar during that period.

Note: Exchange rate index in January 2001 = 100. The exchange rates are monthly averages. In 2018, only monthly data from January to July are presented.
Source: Figure prepared by the author using data obtained from the Board of Governors of the Federal Reserve System (US), U.S. Dollar Exchange rates (monthly rate), accessed 23 July 2018.

Figure 4 – Target Interest Rate Spreads and the Canadian Dollar, 2008-2018

Figure 4 demonstrates the changes in the exchange rate between the U.S. dollar and the Canadian dollar, and the spreads of target interest rates between the U.S. and Canada, from January 2000 to July 2018. It shows that the interaction between these two displays positive correlation, especially after 2007.

Notes: The target interest rate spread represents the difference between the Bank of Canada’s target for the overnight rate and the U.S. Federal Reserve’s target for the federal funds rate. Effective 16 December 2008, the target interest rate for the U.S. is reported as a range with a lower limit and an upper limit. The rates are midweek rates (Wednesday). In 2018, only weekly data from January to July are presented.
Source: Figure prepared by the author using data obtained from the Board of Governors of the Federal Reserve System (US), Federal Funds Target Rate, Federal Funds Target Range – Upper Limit, Federal Funds Target Range – Lower Limit, and Canada / U.S. Foreign Exchange Rate; and  Statistics Canada, Table 10-10-0139-01 Bank of Canada, money market and other interest rates, accessed 30 August 2018.

 

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