Canadian Dollar Fluctuations Essay, Research Paper

The Canadian dollar has declined by over thirty percent versus the United States dollar,

since it was at its highest in 1970. The reason for this is mainly the following factors: the

Quebec factor, the inflation factor, the productivity factor, the growth in government and taxes

factor, and the commodity price factor. These all come together to bring us to what the

Canadian dollar is worth compared to the U.S. dollar today.

The Quebec factor is partly responsible for the decline. ?It is no coincidence that the

Canadian dollar began its descent to 69 cents in November 1976.?? That was the month in which

the Parti Quebecois shocked political observers by winning the Quebec provincial election. It

was the first, and still only, party explicitly committed to separation to assume the reins of power

in Quebec City. ?While it is generally agreed that there is a risk premium built into the Canadian

dollar because of the threat of separation, no one believes that threat is responsible for the

whole, or even the bulk, of the currency’s decline.??

The Canadian dollar is much lower because of separation because of what happened

during the 1980 Quebec referendum. At the beginning of the campaign, in March 1980, polls

showed the Yes side leading. In response, the Canadian dollar very quickly dropped from 87

cents to 83 cents. But in May, when the No side won a resounding 60-40 per cent victory over

the separatists, the Canadian dollar leaped back up. It was at 87 cents again in June. The

currency’s movement in that period suggests a minimum 4 cent risk premium because of

separation.

This is roughly consistent with what happened in the subsequent October 1995

referendum. On the night of the referendum, the television networks were showing the Yes side

with a substantial lead. The Canadian dollar immediately dropped a cent. Then, however, the

votes from Montreal were counted and the momentum began to swing strongly towards the No

side. Over the next several days, the Canadian leaped 3 cents to 75 cents.

Inflation means that the same amount of money purchases fewer goods and services than

before. It follows that if, in a given time frame, currency A undergoes more inflation than

currency B, then A will end up purchasing relatively less goods than B. Obviously, this means

currency A is going to be less valuable than before. People will be more likely to sell the

currency or to buy less of it in favor of currency B. The result is that currency A declines relative

to currency B. This is an application of the Purchasing Power Parity Theorom, which holds that

exchange rates, in the long run, reflect relative national inflation performances.

?While Canada’s inflation rate has been lower than the U.S. rate of late, this has not been

the case over the last twenty five years. The United States has done better than Canada in

containing inflation during that twenty five year period.?? Part of the Canadian dollar’s decline,

according to the Royal Bank’s John McCallum, can be attributed to this.

During the summer of 1998, when the Canadian dollar was hitting

all time lows, the Globe and Mail’s editorial page opined that Canada’s

lagging productivity is behind the currency’s doldrums. Productivity refers

to the returns generated from employing a unit of capital or labour. Rising

productivity means firms are getting more value from each unit of capital

and labour in which they invest.

For example, you hire someone to mow you lawn for the summer at $10 an hour. At the

beginning of the summer, this individual takes one and a half hours to mow your lawn. So you

pay him $15. By the end of the summer, he is mowing the lawn in an hour. Now you only have

to pay him $10. Notice that the productivity of the labour you have employed has increased: you

are getting more grass cut per hour. Notice, too, that your costs have come down as a result. That

is what rising productivity does: it allows us to produce goods and services at a lower cost.

How does that affect the currency? For an exporting country like Canada, productivity’s main

impact is in international competitiveness. Higher productivity, involves lower costs, means that

a country’s exports become more competitive than the goods produced by other countries. That

translates into higher exports, which is supportive of the currency. The opposite takes place in

the case of lagging productivity. Then a country’s costs of production become higher and its

exports cannot be sold at competitive prices. Exports go down and the currency suffers.

Unfortunately, Canada’s productivity has declined relative to the United States in the

crucial area of manufacturing. Between 1979 and 1997, Canadian manufacturing productivity

has grown by 36%. That pales by comparison to the United States. In the same period, U.S.

manufacturing productivity grew by seventy one percent.

The Growth in Government and Taxes factor is a major reason for the drop in value.

?Led by the Fraser Institute, neoconservative commentators like to blame the fall of the

Canadian dollar on the growth of the public sector and increases in taxation. With government

more mettlesome in its regulations and the tax take substantially higher than it was at the

beginning of the 1980’s, people just do not want to invest in Canada.? Investors take their

money elsewhere. So they sell their Canadian dollar assets or do not buy them at all. Either way,

capital flows run against the currency.

The Commodity Price Factor is the most prevalent explanation of the Canadian dollar’s

poor performance. The argument here is that Canada is still a large exporter of natural resources;

not as large as it used to be in the 1950’s, but still about forty percent of its exports are natural

resource based. As such, Canada’s export revenues are very sensitive to commodity price

movements. When those prices rise, export revenues go up, helping the Canadian dollar. But

when commodity prices decline, the Canadian dollar suffers. And that is what has been

happening for most of the last twenty five years.

Believing that the devaluation of the Canadian dollar has indeed had this effect on the

Canadian economy, some economists have proposed that something be done to avoid it from

further decreasing in value. The most noteworthy proposal, along these lines, is North American

currency union. ?Just as the European Union has opted for one currency, the Euro, so the

signatories to NAFTA (the North American Free Trade Agreement) – namely, Mexico, Canada,

and the United States – should adopt one currency for the continent.? No longer would we have

to worry about our dollar declining against the U.S. dollar, since we would share the same

currency.

In conclusion, the Canadian dollar has declined by over thirty percent versus the United

States dollar, since 1970 mainly because of inflation and the fact that government taxes have

gone up. This is why the Canadian dollar is worth what it is today.

Endnotes

? Boreham, Gordon F. & Bodkin, Ronald, Money, Banking, and Finance: The Canadian

Context (Holt, Rinehart, &Winston of Canada, 1993), p. 36

? Ibid. p. 43

? McCallum, John “Drivers of the Canadian dollar and policy implications” Royal Bank of

Canada Current Analysis, August 1998, p. 12

Ibid.

Cooper, Sherry S, “Why we’re getting poorer” The Financial Post, Mar. 5/99, p. 3

Board of Economists, “Do we want one North American currency?” The Financial Post, Jan.

30/99, p. 9

Boreham, Gordon F. & Bodkin, Ronald. Money, Banking, and Finance: The Canadian Context.

Holt, Rinehart, &Winston of Canada, 1993.

Board of Economists. “Do we want one North American currency?” The Financial Post, Jan.

30/99.

Cooper, Sherry S. “Why we’re getting poorer” The Financial Post, Mar. 5/99.

McCallum, John “Drivers of the Canadian dollar and policy implications” Royal Bank of Canada

Current Analysis, August 1998.