Several factors go into how currency value is determined in the Canadian foreign exchange market. Notably, most factors revolve around the trading relationship between Canada and a foreign country and changes in demand and supply of the loonie.
The greatest determinant of the Canadian dollar is crude oil and the country’s foreign exchange earnings. Canada is the fifth-largest crude oil producer, so the demand and supply of crude oil affect the loonie’s value.
Most international trades are priced in the U.S. dollar because it is the leading global currency. When Canada exports oil, it receives payments in U.S. dollars and not Canadian dollars.
Therefore, this country’s revenue depends on the value of the U.S. dollar, and any changes cause positive or adverse effects on Canada’s dollar. For example, if the dollar falls in value, Canada’s prices of goods and services also fall.
Using one currency to determine the value of the country’s economy helps avoid inflation or deflation. It is also important to note that the Bank of Canada does not influence the value of the Canadian dollar, but the dollar’s exchange rates do.
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Another determinant of the value of the currency in Canada is the demand for goods and services. The more crude oil or other goods Canada sells to other countries, the stronger its economy is than those countries, making its dollar worth more.
Factors like interest rates, inflation rates, and economic stability play a significant role in determining the Canadian dollar’s value.
That said, let’s look into the details.
One of the most significant determinants of the Canadian dollar is interest rates. The country’s central bank moves interest rates lower or higher to discourage or encourage the borrowing of loans. When the interest rates are high, loans are costly, preventing people from borrowing
The high-interest rates mean there is a high demand for the currency, and this attracts investors. With the higher rates, they get higher returns when doing currency exchange. High-interest rates increase the attractiveness of the Canadian dollar, raising its value.
On the other hand, when the interest rates are low, the demand for the Canadian dollar is low and doesn’t attract many investors. For that reason, the low demand for a currency decreases its value.
Inflation results from the rise in the prices of goods and services. Prices rise due to increased demand with less supply. Although the high prices are unfavourable to consumers, it leads to the growth of a country’s economy.
When inflation happens, the Bank of Canada will find ways to reduce the rising prices by increasing interest rates to reduce borrowing. Less borrowing means less money in circulation, hence a reduced demand.
Also, higher interest rates increase investors’ demand for the Canadian dollar, raising its value. If deflation happens, prices of goods and services go down.
Inflation without growth in the economy is called stagflation and can cause lagging in the economy, decreasing the value of the Canadian dollar.
When a country’s exports exceed the imports, the country is said to have a trade surplus. For example, Canada’s top imports are machinery and vehicles, while its leading export product is crude oil.
Trade surplus causes demand on the Canadian dollar to increase its value. The opposite happens when the country’s imports exceed the exports. This is called a trade deficit and has adverse effects on the economy. The government spends more than it’s gaining, and the Canadian dollar loses demand. This, in turn, leads to a low value on the CAD.
How much a country can produce with a given level of input influences the currency’s value. The prices of the goods produced compared to the international market prices can be used to determine the exchange rate.
If productivity in Canada is very high, it will price its goods higher due to the competition with other large countries like the U.S. This would, in turn, lead to an increase in exports and trade surplus, increasing the demand for the Canadian dollar.
When a country grows economically, the currency’s value increases. This happens because a growing economy means that most citizens are employed with good wages and can afford to buy goods and services, and make investments.
With economic growth, the country expands in other sectors like the tourism sector. More tourists visit the country, and it also becomes an attractive place for investors to invest. Economic growth causes inflation, which, in turn, can lead to increased interest rates. High-interest rates attract investors, increasing the Canadian currency demand.
Besides the five factors influencing the loonie’s value, the following will also affect currency values in other countries.
Political unrest in a country increases the level of risk for investors. This is because sectors like the tourism industry are not busy. After all, most tourists won’t visit the country at that time. Slow or no economic growth can devalue a country’s currency.
However, when there is peace in the country, most businesses run, leading to economic growth. Investors are also willing to invest in that country, which would lead to a rise in the country’s currency demand.
A country’s government has a lot of say in the country’s economy. This is because they have the power to control and intervene in different sectors. For example, central banks determine the country’s interest rate to cause inflation or deflation.
Governments that print money to pay debts will suffer low currency value. If the government leads the country into practices that result in more economic growth, its currency will have a higher value.
Countries borrow money from international banks to carry on huge projects like building roads or healthcare facilities, or buying expensive machines to increase their production. This leads to economic growth, which, in turn, leads to increased inflation.
More inflation is attractive to investors and increases the country’s currency value. However, if the economic growth does not match the money borrowed, it leads to the devaluation of the currency.
Now that you know how currency value is determined, it is essential to understand why most countries strive to have a high-value currency.
As the price of the Canadian dollar strengthens, the cost of imported goods falls. That happens because the currency in other countries is lower. Since most countries import raw materials, their cost of production reduces, and they enjoy larger profit margins.
Countries with stronger currencies get many local government bonds, which reduces the government’s urge to borrow money from the World Bank.
Countries with a strong currency are more powerful. In addition, the citizens benefit from cheaper vacations in other countries. This leads to improved quality of life, which increases productivity.
Companies in countries with a stable currency identify similar companies in the countries with a low-value currency and buy them. This increases the country’s investments as the purchasing company earns more profits.
A country’s currency value is essential to investors, the citizens, and the country’s economy. Knowing how currency value is determined helps investors predict when a currency can depreciate or appreciate in the foreign exchange market. When the demand for a currency is high in the forex market, its value tends to rise.
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