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A Northern Enigma
Subject Exchange rates
Topic International Finance
Key Words Currency Union, Exchange Rates, Economic Growth
News Story

Many Canadians are upset; others are puzzled about the value of the Canadian dollar in comparison to the U.S. dollar. In April 1974, the Canadian dollar was worth $1.04. Since that time, over almost three decades, the Canadian dollar has declined steadily to a current value of about $.63. In 2001, the Canadian dollar lost 6.25 percent of its value despite an economy that is technically not in recession. The decline in the Canadian dollar has been a bonanza for American tourists, Canadian exporters and U.S. businesses interested in acquiring Canadian firms. On the other hand, Canadians that import American goods or vacation in Florida have been hurt by the devalued Canadian currency.

Canada adopted a floating exchange rate in 1970. Under a floating exchange rate system, market forces determine the value of the Canadian dollar. One explanation for the plight of the Canadian dollar is that the foreign exchange market simply prefers other currencies. These preferences, however, may not be without foundation. Economists say that the Canadian dollar has been undermined by an outflow of capital. A recent change in Canadian law, allowing holders of individual retirement accounts to increase their holdings of foreign securities from 20 to 30 percent, has probably added to the outflow. Prospects for productivity improvements and economic growth may also be a contributing factor. Capital equipment, especially the more sophisticated type, is imported from the U.S. As the American dollar increases in value, this equipment becomes relatively more expensive and Canadian firms have substituted relatively inexpensive labor rather than buying new equipment.

Some economists have proposed a currency union to include the United States, Canada and Mexico as a solution to Canada's dollar problems. Not everyone supports this proposal because it would require that Canada surrender its ability to control interest rates, one of the country's most important tools for influencing the direction of the economy.

(Updated February 13, 2002)

Questions
1. Explain how the value of the Canadian dollar is determined under a floating exchange rate system. What are the primary determinants of the demand for Canadian dollars? What are the primary determinants of the supply of Canadian dollars?
2. Who gains and who loses when the Canadian dollar depreciates relative to the U.S. dollar?
3. What is a currency union? How would the adoption of a currency union support the value of the Canadian dollar?
Source Anthony DePalma, "Showing in Canada: The Mystery of the Falling Dollar," The New York Times, January 9, 2002.

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