Canadian Exchange Rate Essay Research Paper IntroductionThe

Canadian Exchange Rate Essay, Research Paper

Introduction

The Canadian Dollar has undergone a significant depreciation over the past 10 years. The drop in relative value of our currency has caused a great deal of consternation not only among economists but also in the media and consequently the general public has well. Ordinary citizens experience first hand the effects of such depreciation every time they go to our most frequented vacation spot, the United States. While economic variables are not usually the subject of casual debate, the exchange rate trend has even permeated our most beloved conversation topic, professional hockey. Despite the popularity of the subject, consensus and clarity are rarities. What has happened to the value of the Canadian dollar simply requires quick glance at the data, however why it has happened is rather more contentious. This paper will analyze the long term effect of the Canadian exchange rate relative to the US dollar. The first section will serve as a background piece on exchange rates. In the next section, I hope to provide the reader with an appreciation of what has happened to the value of the Canadian dollar over the last decade. In the third part I will go through the economic theory behind the determination of a long term exchange rate. Finally in the fourth section, I will try to relate the theory with the trend exibited by the Canadian dollar.

Section 1 Background

While the subject is often discussed, there still exists many misconceptions about what the exchange rate actually is. The exchange rate is the price of a foreign currency in Canadian dollars on the foreign exchange market. Like in any market, the price is determined by the intersections of demand and supply. Demand for a currency is made up of all those who want to buy or hold an asset in that particular currency. For example, importers need to convert the Canadian dollars into foreign currency in order to purchase foreign goods. Similarly investors who wish to hold foreign assets must pay for them in foreign currency and therefore need to convert Canadian dollars. The supply is made up of those wishing to buy Canadian dollars; these people include those buying Canadian export and those investing in Canadian assets. The intersection of theses two opposing actions, buying and selling Canadian dollars determines the volume traded and at what price or the exchange rate. Due to geographic proximity, free trade and economic integration, the foreign currency most demanded and most sold by Canadians is the US dollar. The value of our currency is most reflected in the price of the US dollar. This paper will therefore use the price of a US dollar in terms of Canadian dollars as the value of the Canadian dollar.

In the previous section I assumed that the currency is flexible, that is to say that the price is based on foreign exchange market activity. It is however possible to fix the price of a currency at a particular level. In order to accomplish this, the central bank must be willing to buy or sell the perceived excesses of the market; i.e. the bank must buy or sell enough Canadian dollars so that the price remains stable. If such a practice becomes unsustainable the central must change the fixed price or move the peg. Such a system, known as the Breton Woods system was predominant in post-world war II industrialized economies. However by the Nineteen sixties Canada, Canada like many other nations, moved to a flexible exchange rate system. It is important not to assume that because the currency is not officially fixed at some level, that the central bank does not play a role in determining its price. The central bank still intervenes in the market but not to hold the price at a certain level, but rather to prevent to price from fluctuating rapidly up or down. This type of exchange rate regime is known as a dirty float.

Section 2 Observations

Over this past decade, the value of a Canadian dollar has dropped nearly 25%. In 1990, a US dollar could be purchased for 85 cents Canadian and by the end of 2000 the price had dropped to 65 cents. This decline however, has not been constant. Between 1990 and the end of 1991, before the recession, the dollar actually appreciated to three cents. The end of ninety-one marked the beginning of a steep depreciation of the dollar. In fact notwithstanding a few blips, the price of a dollar only leveled out in 1995 but not before sinking to 71 cents. This equilibrium did not last very long; by the beginning 1997, the dollar was sliding again only to stop two years later at around 65 cents. This all-time low was most likely considered unsustainable and the price slowly crept its way back towards the 70-cent level throughout 1999 only to drop back down to 65 cents by the end of 2000.

That Canadian dollar over the 1990’s has steadily declined 25%, cannot be simply what is known as a market error. The invisible hand of Adam Smith has not been waving around the foreign exchange and accidentally knocking down the Canadian dollar. A steady long term trend downward.

ds means that economic fundamentals are at play.

The question of what economic fundamentals have forced the depreciation of the Canadian dollar is indeed a sordid one. Over the years economists have developed several theories regarding the determinants of exchange rates. However because the downfall of the Canadi