Exchange Rates and Commodity Prices

Over the last two years, the value of the Canadian Dollar has greatly appreciated relative to the American Dollar. In the article "A Beginner's Guide to Exchange Rates and the Foreign Exchange Market we looked at three factors that can cause a rise in the value of the Canadian Dollar.

1. A rise in commodity prices
2. Interest rate fluctuations
3. International factors and speculation

Many economic analysts believe that the rise in the value of the Canadian Dollar is due to a rise in commodity prices stemming from increased American demand for commodities. Canada exports a great deal of natural resources, such as natural gas and timber to the United States. Increased demand for a good such as timber, all else being equal, causes the price of that good to rise and the quantity consumed of that good to go up. When Canadian companies sell more goods at a higher price to Americans, this causes the Canadian dollar to gain in value relative to the U.S. dollar, through one of two mechanisms:

Mechanism 1 - Canadian Producers Sell to American Buyers - American Buyers Pay in Canadian Dollars

This mechanism is quite straightforward. The American Buyers need to buy Canadian Dollars and sell American Dollars on the foreign exchange market. This causes the quantity of American Dollars to rise on that market, and the quantity of Canadian Dollars to fall. To keep the market in equilibrium, the value of the American Dollar must fall (to offset the larger quantity available) and the value of the Canadian Dollar must rise.

Mechanism 2 - Canadian Producers Sell to American Buyers - American Buyers Pay in U.S. Dollars

This one is only slightly more complicated. Canadian producers will often sell their products to Americans in exchange for American Dollars, as it is inconvenient for their customers to use foreign exchange markets. However, the Canadian producer will have to pay most of their expenses, such as employee wages, in Canadian Dollars. No problem; they sell the American Dollars they received from sales, and purchase Canadian Dollars. This then has the same effect as mechanism 1.

Now we've seen how the Canadian and American Dollars are linked to changes in commodity prices due to increased demand, we'll see if the data matches the theory.

Be Sure to Continue to Page 2 of "Exchange Rates and Commodity Prices"