Wednesday, September 26, 2007

A breif lesson on the exchange rate

Yes! Back to basics. Although I will not try to predict the future, I can share some general comments about how the exchange rate can affect the economy.

Say the exchange rate appreciates from 62 cents to $1US. And, gold is worth $736.20US oz (or so). And, you are a gold miner in Nova Scotia, who sells their gold in New York in US$. How will will the exchange rate appreciation affect how much your cost is worth in Canadian dollars? Well, it depends on the exchange rate. If the Canadian dollar is valued at $0.70US (which is the same as saying one US dollar is worth $1.43CND), you will receive $1051.71CND ($1.43*$736.20=$1051.70) in return for 1oz of gold. At parity you receive only $736.20 ($1*$736.20=$736.20). What if we price is fixed in Canadian dollars? The price will raise from the point of view of our American customers because it will take more US dollars to buy the same amount of Canadian gold. Taking our mining example future, because the exchange rate will affect the price we get for our gold, it will also affect production and employment at the mine, and therefore also the wages and profits, and also future investment plan. Finally, the markets where the workers' wages and owner's profits are spent will also be affected overtime.

On the other hand, the exchange rate will change the price of stuff we buy from other countries as well (books on line, foreign cars, and bananas for example) - these should go down in price (overtime) with the Canadian dollar climbs.
Lastly, because the prices are changing, it might also affect how much we demand these products. For example: If Dell computers fall in price, will Canadians buy more? How about sweaters from China?

Overall, the short-term and long-term impacts of the appreciation can be hard to conceptualize. It will depend on many factors, like how businesses and policy makers respond to the appreciation, but more fundamentally, it will depend on why the exchange rate moved: Was it because the things we produce are worth more (like oil) or was it because people think that Canada is a good place to invest compared to other places around the world? As you can guess, these have very different implications on the Canadian economy and it is often hard to determine what has moved the currency – I will leave this job to our trusted policy makers and market commentators . In short, it is very hard to determine the full set of costs and benefits of a given currency movement – views often differ - and the assumptions about the responses of consumers, businesses, and policy markers, in Canada and other countries, (and the interaction of these behaviours) can drive the results.


MadJenny said...

Thanks! That was really well explained for the economically unenlightened!

Canadian Economist said...

Thanks for reading. I am so glad you liked it!!