More of this Feature • Part 1: Exchange Rates - What are they? • Part 2: Exchange Rates - Arbitrage • Part 3: Exchange Rates - Supply • Part 4: Exchange Rates - Demand • Part 5: Case Study: Canada - Introduction • Part 6: Case Study: Canada - Commodity Prices • Part 7: Case Study: Canada - Interest Rates • Part 8: Case Study: Canada - International Factors

Factor 1: Commodity prices.

Commodities such as these represent almost 40 percent of Canadian exports. As shown in the following chart, the Commodity Price Index fell sharply several times between 1990 and 2002, particularly during the Asian crisis of 1997-1998:

Note that I divided the Commodity Price Index (CPI) by 100, so I could show both the CPI and the exchange rate on the same chart.

It would appear that both the exchange rate and the Commodity Price Index suffered similar declines during 1997 and 1998. I calculated the correlation coefficient between the exchange rate and the (unscaled) Commodity Price Index between January 1997 and December 1998. The correlation coefficient between the two was a whopping 0.94, indicating a particularly strong positive relationship between the two. We cannot infer from this that the drop in the Commodity Price Index necessarily caused a drop in the exchange rate, but we can say that the two changed in the same direction most months during this period. This strong relationship did not occur before or after this period. The correlation coefficient for 1990-1996 was -0.31, and for 1999-2002 was 0.29.

Now consider why this relationship might occur. After a reduction in lumber prices, an American construction company now needs less Canadian dollars to purchases its Canadian lumber. The reduction in lumber prices will likely cause the company to increase its purchases, but their total expenditures will likely be lower than they were before. Because of this American construction companies will need to buy less Canadian dollars on the foreign exchange market to get the lumber they need. The demand for Canadian dollars will decrease, and the price of the Canadian dollar relative to all currencies including the U.S. one will go down. We would expect that all else being equal, a reduction in commodity prices will occur at the same time as a reduction in the exchange rate. This appears to have happened during the Asian crisis of 1997-1998 and possibly since then as well.

This reduction in commodity prices represents only a partial explanation for the decline in the Canadian dollar.

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