Introduction


The exchange rate refers to the assessment of value of the US dollar against the values of currencies of other countries. Such a rate helps determine how much we pay for imported goods and services and how much we receive for what we export, among other things. When the worth of the US dollar drops, imports become more expensive, and we tend to reduce the volume of our imports. Simultaneously, other countries will pay LESS for some of our products and that will tend to boost export sales. If imports and exports are a substantial part of a countrys economy, as is the case with Canada, the exchange rate plays a particularly important role in our economy. The exchange rate between two countries currencies is particularly important if the two countries are heavily involved in trade.


What factors affect an exchange rate?


A countrys exchange rate is typically affected by the supply and demand for that countrys currency in international exchange markets. This is typically known as a floating exchange rate. If demand, for say dollars, exceeds supply, then the assessment of worth of the dollar will go up. If however, the supply of dollars exceeds demand, then its assessment of worth will go down. A huge amount of money is bought and sold on international exchange markets for many different currencies.


Several factors influence the supply of, and demand for, a given countrys currency.


If INTEREST rates are HIGHER in, say, the US than in other countries, then investors WILL choose to invest in the US, increasing demand for the dollar, provided that the expected rate of inflation is not higher in the US than among our trading partners. If INTEREST rates are LOWER in the US than in other countries, investors will choose NOT to invest in the US, decreasing demand for the dollar.


If the US INFLATION rate is HIGHER, investors are LESS likely to prefer the US -even with higher interest rates- because of the expectation that the value of the dollar will be ERODED by inflation. If our INFLATION rate is LOWER, investors are MORE likely to prefer the US, because there will be NO expectation that the assessment of worth of the dollar will erode.


Trade balance also has an effect on a countrys currency. If world prices for what a country exports rise in comparison with the cost of that countrys imports, that country will be earning more for its exports than it pays for its imports. The more demand there will be for that countrys currency, the better the deal becomes. If investors are confident that the US economy will be strong, they will be MORE likely to buy American assets, pushing UP the dollars assessment of value. If investors are not so confident that the economy will be strong, they will be LESS likely to buy the countrys assets, pushing the dollars worth DOWN.