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Analyzing the Value of the Canadian Dollar - Introducing MERT

Introducing MERT - The Moffatt Exchange Rate Toy

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On November 7, 2007 I made the remark that the Canadian Dollar was overvalued, but other than appealing to the idea of purchasing power parity I had no justification for that claim. Becuase of that, I decided to come up with a very simple way of estimating whether or not the Canadian Dollar is overvalued. As it turns out, the loonie might not be overvalued after all.

What is MERT?

MERT, or the Moffatt Exchange Rate Toy, is a very simple formula to estimate if the Canadian Dollar is overvalued or undervalued relative to its U.S. counterpart. It should not be taken as a serious piece of technical analysis (hence the name "toy"), but rather is a way of thinking about movements in the Canadian Dollar. MERT contains only three input variables:

Despite containing only these three variables, MERT is a relatively accurate predictor of the Canadian Dollar. This is shown by both the 2001-2006 period for which the toy was calibrated for and the 2007 period which was not considered when the toy was developed.

Calculating MERT Values

The MERT value in cents is calculated as follows:

MERT value = 48.26077 + Price Of Oil * 0.621086 + Interest Rate Gap * 1.830607

Where the Interest Gap = CDN Overnight Rate - US Federal Funds Rate.

For back-of-the-envelope calculations, I use the figures 48.26, 0.62 and 1.83 for the respective parameter values.

How Were the MERT Parameter Values Estimated?

Data was taken for the six year period 2001-2006 and a linear regression was run in the same method as Is the Value of the Canadian Dollar related to Oil Prices?. The parameter values and standard errors were as follows:

Intercept 48.26076935 (0.356750207)
Oil Price 0.621086197 (0.007523318)
Interest Rate Gap 1.830606527 (0.12301649)

The R-squared was 0.887288983, so 88.7% of the variance in the Canadian Dollar is "explained" by oil prices and interest rate gap.

How Well Has MERT Performed in 2007?

MERT has, on average, undepredicted the value of the Canadian Dollar by 2.82 cents in 2007. Or, alternatively, the Canadian Dollar has been, on average, overvalued by 2.82 cents in 2007, according to MERT. This over-prediction has not been consistent and was most pronounced in January, May and June, as shown by the 2007 period graph. After each of these periods of overvaluation, the MERT value and the actual value of the Canadian Dollar do re-align.

Is There a Theoretical Justification For the Choice of Functional Form?

Absolutely not. This is a toy model, so there is no reason in theory why the relationship between the price of oil and the Canadian Dollar should be linear.

Why Does The Canadian Dollar Go Up When Oil Prices Go Up?

The reason why the Canadian Dollar goes up when oil prices go up and the U.S. Dollar goes down has to do with the fact that Canada is a next exporter of oil and the U.S. is a net importer.

Oil is typically denominated in U.S. Dollars. When the price of oil goes up, so American firms increase the total dollars spent on oil from Canadian oil companies. The Canadians are left with a lot of U.S. Dollars, but they need to pay their workers, taxes, etc. in Canadian Dollars.

Here is where we need to go to our Econ 101 framework of supply and demand. The Canadian firms need to reduce their holdings of U.S. Dollars (in order to get Canadian Dollars), so they increase the supply of U.S. Dollars on foreign exchange markets. This shifts the supply curve to the right, causing the price of U.S. Dollars to fall.

Why Does The Canadian Dollar Go Up When Canadian Interest Rates Go Up?

When Canadian interest rates go up Canadian bonds become more attractive to international investors. For them to buy Canadian bonds, they need Canadian Dollars so the demand for Canadian Dollars rises, pushing up the value of the loonie.

Similarly when U.S. interest rates go up American bonds become more attractive to international investors. For them to buy U.S. bonds, they need U.S. Dollars, which pushes up the value of the U.S. Dollar.

What Are The Implications of MERT?

If MERT is correct then it is clear that oil prices are the main driver of the Canadian Dollar. Interest rates, while important, play a secondary role.

Some in Canada have called for the Bank of Canada to lower rates by 25 basis points (0.25%) in order to reduce the price of the Canadian Dollar. But this would only have the result of pushing the Canadian Dollar down about .457 cents (that is less than half-a-cent). If MERT is correct, then monetary policy is an ineffective tool for influencing the value of the Canadian dollar in a time of highly fluctuating oil prices.

If you have any questions or comments about MERT, please use the feedback form.

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