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 for 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.
Explanation for the Recent Performance of the Canadian Dollar
As shown in Figures 1 and 2 in the Appendix, from January 2002 to November 2007, the Canadian dollar increased from a low of 62 cents U.S. to a high of 1.04 dollars U.S. due to rising energy prices and strong U.S. demand for Canadian exports.
In response to the 2007 housing market crash, the U.S. Federal Reserve Bank reduced its target interest rate from 5.25% in September 2007 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 (see Figure 3 in the Appendix).
Consequently, 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. As illustrated in Figure 4 in the Appendix, 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 U.S. in March 2009 to 1.05 dollars U.S. 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 to 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 the U.S. dollar reduced the value of the Canadian dollar to below 70 cents U.S. in January 2016.
Between January 2016 to February 2020, the slow but steady recovery in energy prices increased the value of the Canadian dollar from 70 cents U.S. to 75.3 cents U.S.
After the COVID-19 pandemic began in March 2020, investors’ demand for U.S. dollar-denominated assets increased significantly due to the U.S. dollar’s status as a safe haven during periods of economic uncertainty and financial market turbulence. This surge in demand for U.S. dollar-denominated assets contributed to a decline in the value of the Canadian dollar, from 75.3 cents U.S. in February 2020 to 71.1 cents in April 2020.
From April 2020 to May 2021, a sharp rise in energy prices and Canada’s higher interest rates compared to those of the U.S. led to an increase in the value of the Canadian dollar from 71.1 cents in April 2020 to a peak of 82.5 cents U.S. in May 2021.
From May 2021 to June 2024, the value of the Canadian dollar fell from 82.5 cents U.S. to 73 cents U.S. due to lower energy prices and Canada’s lower interest rates compared to those of the U.S.
APPENDIX
Figure 1 – The Canada–U.S. Exchange Rate, U.S. Dollar per Canadian Dollar, 1951–2024
Note: The exchange rates are monthly averages. In 2024, monthly data are presented from January to June only.
Source: Figure prepared by the Library of Parliament using data obtained from Statistics Canada, “Table 33-10-0163-01: Monthly average foreign exchange rates in Canadian dollars, Bank of Canada,” Database, accessed 15 August 2024; and Statistics Canada, “Table 10-10-0009-01: Foreign exchange rates in Canadian dollars, Bank of Canada, monthly,” accessed 15 August 2024.
Figure 2 – Real Commodity Prices and the Canadian Dollar, 2000–2024
Note: The Commodity Price Index in January 2000 was 100. The exchange rates are monthly averages. In 2024, monthly data are presented from January to July only.
Source: Figure prepared by the Library of Parliament using data obtained from Bank of Canada, Commodity price index; Statistics Canada, “Table 33-10-0163-01: Monthly average foreign exchange rates in Canadian dollars, Bank of Canada,” Database, accessed 15 August 2024; and Statistics Canada, “Table 10-10-0009-01: Foreign exchange rates in Canadian dollars, Bank of Canada, monthly,” Database, accessed 15 August 2024.
Figure 3 – World Currencies’ Performance Against the U.S. Dollar, Exchange Rate Index, 2001–2024
Note: The exchange rate index in January 2001 was 100. The exchange rates are monthly averages. In 2024, monthly data are presented from January to July only.
Source: Figure prepared by the Library of Parliament using data obtained from Federal Reserve Bank of St. Louis, Federal Reserve Economic Data, Monthly Rates.
Figure 4 – Target Interest Rate Spreads and the Canadian Dollar, 2000–2024
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 2024, weekly data are presented from January to July only.
Source: Figure prepared by the Library of Parliament using data obtained from Federal Reserve Bank of St. Louis, Federal Reserve Economic Data (FRED), Federal Funds Target Rate; Federal Reserve Bank of St. Louis, FRED, Federal Funds Target Range – Upper Limit; Federal Reserve Bank of St. Louis, FRED, Federal Funds Target Range – Lower Limit; Federal Reserve Bank of St. Louis, FRED, Canadian Dollars to U.S. Dollar Spot Exchange Rate; and Statistics Canada, “Table 10-10-0139-01: Bank of Canada, money market and other interest rates,” Database, accessed 15 August 2024.
By Shaowei Pu, Library of Parliament.
Revised by Mehrab Kiarsi, Library of Parliament
This publication is based on a previous Library of Parliament publication by Michael Holden.