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October 13, 1978
$ Canadian: An Excepti on
Over the past year, the international
financial news has been dominated by
the continuing slide in the value of the
u.s. dollar. The decline was steep last
winter, and after a modest recovery in
April and May, the dollar resumed its
downward trend against most major
currencies. Indeed, from September
1977 to September 1978, the dollar
fell by 19 percent against the D-mark,
by 57 percent against the Swiss franc,
and by 42 percent against the Japanese
yen.
Yet headline writers have largely ignored the fact that, for almost two
years now, the u.s. dollar has risen
strongly against the Canadian dollar.
The latter began to depreciate from its
peak value of U.s. $1.03 in late October 1976. It declined irregularly
throughout 1977 and early 1978, hitting a low of U.s. $0.87 this past April. It
rose several cents by early summer,
but has since fallen below even its April
lowpoint.
Since Canada is by far our largest trading partner - accounting for nearly 40
percent of our merchandise exports
and imports - the behavior of the
Canadian-U.s. exchange rate plays a
major role in determining the movements in the overall or
ed value of the U.s. dollar. (The
trade-weighted value is simply an average of the dollar exchange rates of
our major trading partners, in which
N
each country's exchange rate is
weighted by the fraction of total U.s.
trade which that country handles.)
Over the last twelve months, the
trade-weighted value of the u.s. dollar has declined only 9 percent, as
compared with the outsized depreciations against certain individual currencies such as the D-mark and the yen.
It is easy to look back and suggest ad
hoc explanations as to why the Canadian dollar has been different. For example, one could point to the political
uncertainties surrounding the rise of
the separatist Parti Quebecois in Quebec. But can the depreciation of the
Canadian dollar be explained on narrower economic grounds? Could its
decline have been predicted? Let's
consider several alternative explanations of why the Canadian-U.s: ex- change rate has moved the way it has
over the last two years.
B;;.ilIallilce
of paymellilt§
Perhaps the most common method of
forecasting exchange rates is to analyze movements in a country's balance of payments. The logic of this
approach is simple: under floating exchange rates, if a country biJYs more
abroad than it sells, the resulting excess supply of home currency should
drive down its value. Practically, however, it is difficult to decide which of
the different balance-of-payments
measures to use for analysis. The two
(continued on page 2)
most familiar are the balance of
trade - the difference between the
value of merchandise exports and
merchandise imports - and the balance on current account - net exports
of goods and services plus net unilateral transfers (excluding military grants).
Canada's balance of trade improved
from a deficit of C$0.45 billion in 1975
to a surplus of C$1.34 billion in 1976,
and then strengthened further in 1977
to a C$2.92 billion surplus. By contrast,
the U.s. balance of trade went from a
surplus of $9.05 billion in 1975 to a
1976 deficit of $9.35 billion, from
where it declined to a $31.10-billion
deficit in 1977. Thus, a comparison of
balance-of-trade statistics would suggest that the Canadian dollar should
have gained against the
dollar during the period, while in fact it depreciated. The current-account statistics tell
the same qualitative story as do the
trade numbers, i.e., a strengthening of
Canada's external position vis-a-vis
the
position from 1975 through
1977. Any approach based on balance-of-payments analysis, therefore,
would have led the unwary exchangerate forecaster astray.
u.s.
u.s.
lPaJJ!I'chasDng
powell' parity
Another common approach to forecasting exchange rates is based on the
notion of "purchasing power parityN,
which states that for exchange rates
to be in equilibrium, a unit of any currency must command the same purchasing power abroad as at home. Put
slightly differently, goods which can
be traded internationally must cost the
same in all countries. It follows that, if
rates of inflation are different between
two countries, the exchange rate linking those countries must move to offset that difference.
2
Changes in such things as tariffs and
transport costs can upset the simple
relationships described here. And
changes in international capital flows
can drive an exchange rate at least
temporarily away from the value implied by the theory of purchasing power parity. The theory, therefore,
provides a better long-run than shortrun explanation of exchange-rate
movements.
Again, there is the practical problem
of choosing which measure of "theN
rate of inflation to use to test the theory. It is generally agreed, however,
that a wholesale-price index is preferable to a consumer-price index for purposes of international comparisons,
since tradeable goods comprise a
greater portion of the wholesale-price
index. Moreover, since purchasingpower parity is related to underlying
trends in exchange rates, it is reasonable to choose a price index which
omits the often""volatile prices of food.
Thus, the best comparison is between
non-food finished-goods indexes.
On an annual basis, the price/
exchange-rate relationship has not
been very exact. During 1976, Canadian inflation far outpaced U.s. inflation, but the exchange rate fell only
slightly; during 1977, the spread between Canadian and
inflation
rates narrowed significantly but the
Canadian dollar still fell precipitously.
For the two years as a whole, though,
the average inflation-rate differential
of 3.3 percent roughly equalled the
average 3.8-percent depreciation of
the Canadian dollar. For this longer period, therefore, an exchange-rate
forecaster would have done well by
following the behavior of inflation in
the two countries.
U.s.
Monetall'Y fadolf'§
This discussion of purchasing power
parity implies that inflation differentials
are the principal cause of exchangerate movements. Yet the financial
press often talks of the causation going
in the opposite direction. Thus we frequently read that inflation in the u.s.
has been exacerbated by the depreciation of the dollar via the cost-push
pressures generated by more expensive imports. The monetary approach
to exchange rates subsumes these different interpretations by viewing both
inflation differentials and exchangerate changes as the results of a third
factor: international differences in the
rates of money growth.
expansion in any given country leads
not only to domestic inflation but also
to a depreciation of that country's
currency, as the currency's price falls in
response to its excess supply.
By definition, the exchange rate is the
price of foreign money in terms of domestic currency. The nominal supply
of money in each country is largely determined by that nation's central
bank. National price levels and the exchange rate must then adjust to induce individuals in each country to
hold willingly the nominal quantity of
money supplied. Excessive monetary
In sum, then, both the purchasingpower parity and monetary theories
of exchange rates could have been
used to foretell the direction and
rough size of the change in the Canadian-U.s. exchange rate over the last
two years. In contrast, the balance-6fpayments approach would have predicted just the opposite of what actualIyoccurred.
Over the last several years, the broadly
defined (M2) money supply has expanded much more rapidly in Canada
than in the U.s. While M2 was growing in the U.s. by 10.9 percent in 1976
and by 9.8 percent in 1977,it was ballooning in Canada at rates of 19.7
percent and 14.1 percent, respectively, in those two years. Not surprisingly,
as in the case of any good in excess
supply, the price of the Canadian dollar
has fallen.
ladan Amir-Aslani and
Kenneth froewDss
Percentage
Points
12
Change(%)
Canada M2 Growth
? less US. M2 Growth
10
...co(
8
6
6
4
0
'-"\
/
2
3
,/
0
Change in
Canada/US.
Exch. Rate
1976
3
1977
-3
>-
1 978-
-6
9
U01§Ul4SEM" 4E1n flo uo§aJO <a EpEAaN
!!EMEH <a ElUJoJllE:J
EUOZlJV
Q
(\J)
4I \ill\2?em
:{),
D ATA- T\lViEllFTH
FEDERAlllUSERViE
(Dollar amounts in millions)
Selected Assetsand liabilities
!LargeCommercial Banks
Loans(gross,adjusted)and investments*
Loans(gross,adjusted)- total
Securityloans
Commercial and industrial
Realestate
Consumer instalment
U.s. Treasurysecurities
Other securities
Deposits(lesscashitems)- total*
Demand deposits(adjusted)
U.s. Government deposits
Time deposits- total*
Statesand political subdivisions
Savingsdeposits
Other time depositst
LargenegotiableCD's
Weekly Averages
of Daily Figures
Member Bank ReservePosition
ExcessReserves(+)/Deficiency(-)
Borrowings
Net free(+ )/Net borrowed (-)
federal Funds-Seven large Banks
Interbank Federalfund transactions
Net purchases(+)/Net sales(-)
Transactionswith U.s. security dealers
Net loans (+)/Net borrowings (-)
Amount
Outstanding
Change
from
9/27178
9120178
118,067
94,890
1,927
27,821
33,039
17,674
9,278
13,899
113,973
30,279
1,042
80,730
6,448
31,838
38,810
19,710
+
+
+
+
+
+
-
-
+
-
+
+
+
Changefrom
year ago
Dollar
Percent
209
411
161
106
147
116
137
65
181
477
115
278
37
225
91
28
+
+
+
+
+
+
+
+
+
+
+
+
17,228
16,607
260
3,722
7,100
3,935
986
365
14,564
2,554
83
11,588
1,170
46
+ 9,213
+ 7,780
Week ended
Week ended
9127178
9120178
+
27
54
81
70
86
16
947
+
117
503
+
281
o4EPI
E)ISEIV
\ill\2?J(dI \ill\2?C£
(\J):J) <§
'J!ii?J'OJSPUi?..I:J
Ui?S
(;SL 'ON InW"tBd
ClIIYd
319YlSOd 's'n
llYW SSY1:::P
0
+
+
+
+
+
+
+
+
+
+
+
+
-
+
+
17.08
21.21
15.60
15.44
27.37
28.64
11.89
2.56
14.65
9.21
8.65
16.76
22.17
0.14
31.13
65.21
Comparable
year-ago period
+
+
49
28
21
883
+
274
*Includes items not shown separately.tlndividuals, partnershipsand corporations.
Editorial comments may be addressedto the editor (William Burke) or to the author... .
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