The flexible exchange rate

Sean Gordon: Hi, I'm Sean Gordon. I work in the communications department here at the Bank of Canada. And today I'm joined by Konrad Zmitrowicz, who works in the Canadian Economic Analysis Department. And is an economist. Thank you for being here, Konrad. Appreciate it.

Konrad Zmitrowicz: Thanks very much, Sean. It's a real pleasure.

Sean Gordon: Firstly, and perhaps most importantly, what is a flexible exchange rate? How does that work?

Konrad Zmitrowicz: Sometimes it's a little bit easier to describe these things by the opposite. So, a fixed exchange rate is when the value of our currency, the Canadian dollar, the loonie, is fixed in value against another currency or a precious metal such as gold.

Sean Gordon: Gold is how it used to be, sort of 50 or 60 years ago.

Konrad Zmitrowicz: Exactly. By contrast, the flexible exchange rate is when the value of the Canadian dollar can move up and down, based on the movements in financial markets. There's no predetermined level that the Canadian dollar can be on any day. And generally, it will move in line with the economic conditions that prevail in Canada.

Sean Gordon: So why does the bank favour a flexible exchange rate system, rather than fixed? What are the benefits of that?

Konrad Zmitrowicz: One of the main benefits of having a flexible exchange rate is that it can act as a shock absorber for the economy. What do we mean exactly by that? You can think of it similarly to the shock absorbers on your car. It can make the drive a bit more smooth when it's a bumpy road. One particular instance you can think of is there is a decline in the demand for a key Canadian export, let's say oil. When the demand for Canadian oil declines, it would also lead to a decline in the value of the Canadian dollar. Now, that decrease in the value of the Canadian dollar will make imports into Canada more expensive, but it’ll also make it a little bit more competitive for the other goods that we produce to be sold on international market.

Sean Gordon: Because they become cheaper in other words.

Konrad Zmitrowicz: They become cheaper.

Sean Gordon: Relative to other currencies.

Konrad Zmitrowicz: Exactly.

Sean Gordon: So, one of the main tools that the Bank of Canada has is the key interest rate policy interest rate. And I'd be curious to know how interest rate changes by central banks, including Canada's, interact with exchange rate movements, in the flexible exchange market. How does that work?

Konrad Zmitrowicz: The Bank of Canada's mandate is to control inflation. It's to keep it within a 1 to 3% range, usually in the midpoint of that band is where you should expect it to see.

Sean Gordon: So 2%, generally. And it's been like that for a while.

Konrad Zmitrowicz: A while. Having a flexible exchange rate allows us to focus on that goal. Say for instance, we have that goal, but also we wanted to keep the value of our exchange rate fixed. It would be really difficult to be able to achieve both objectives, because in the case where we had to fix the exchange rate, keep the exchange rate fixed, there's a number of factors that could cause the value of the Canadian dollar to change against other currencies. And we may have to say, raise interest rates to try to keep that value of the Canadian dollar the same, which may not help with the inflation control objective that we have here at the Bank of Canada.

Sean Gordon: So, there's tradeoffs, I guess, associated with all of this.

Konrad Zmitrowicz: That's right.

Sean Gordon: So, you're talking about sort of the effect of external forces to some degree as well. I mean, what sorts of external forces are we talking about and how do they interact in terms of the currency markets, and also on the Canadian economy?

Konrad Zmitrowicz: This is a really great question. So, it kind of boils down to what determines the value of the Canadian dollar at the end of the day. And I think you could kind of boil it down to three factors overall. There's domestic economic conditions, these could be things such as, the inflation outlook in Canada, the strength of productivity growth in Canada. It could also be just the underlying political situation in Canada, real things that are determined within our country. There's also external factors, like you suggested, the value of commodity prices. We're a major commodity producer in this country, but we don't really determine their price. They're determined on international markets. Those prices tend to fluctuate a lot and can impact the value of our currency. The third thing that's really important is, interest rates and particularly interest rate differentials. So the difference between interest rates in Canada versus foreign countries. So, in the case of where, say, Canada's interest rates become higher than those in the United States, you'll get a situation where, for similarly-priced Canadian assets, their value goes up. This will attract foreign capital into Canada and it'll cause the currency to appreciate. So, these are some of the things that can determine the value of the Canadian dollar overall.

Sean Gordon: And so, acting as a shock absorber is one thing. But I'm guessing also that there is an effect of all of this from the flexible exchange system on the overall trade and investment environment. And I'm curious to know how that works as well. Like, what are the what are the direct effects, or what are the mechanics of flexible exchange rates, in regards to trade and investment?

Konrad Zmitrowicz: It's really interesting in the case of Canada in particular, because we tend to import a lot of machinery and equipment in Canada. So, in the investment space, when the value of the Canadian dollar goes up, it's cheaper for us to import, machinery and equipment, say, from the United States or from Japan. And these usually have positive productivity effects for those businesses that import these machines.

Sean Gordon: And productivity effects, meaning that we're just more efficient at making things.

Konrad Zmitrowicz: Yeah. You're using more up-to-date software. The machines run more efficiently. You're able to produce your goods and services more cheaply than you were before. On the other side, while the value of the Canadian dollar going up can help to import those goods, they also make the value of our exports less competitive on international markets. So, there's kind of an offset that happens.

Sean Gordon: Because they become relatively more expensive.

Konrad Zmitrowicz: Exactly.

Sean Gordon: Often the US dollar is talked about as a kind of measuring stick currency. It's the one against which basically all other currencies are measured. It's the world reserve currency. It's preeminent in terms of international trade. And I'm wondering what happens when the value of the US dollar itself changes and what leads to those changes?

Konrad Zmitrowicz: So, the US dollar—you're absolutely right—is the global reserve currency. So, what does that mean in practice. It means some of the most important things that we trade in are usually traded in the US currency. Almost all commodity prices—oil, wheat—are traded in the US dollars. A lot of the manufactured goods across the world are usually sign and contracts based on US dollars.

Sean Gordon: So, in other words, there are factors that can be for good or bad, whether it helps improve the US economy or in some way shocks it negatively, that are going to have spillover effects basically throughout the currency markets, which puts an effect on Canada as well.

Konrad Zmitrowicz: Absolutely.

Sean Gordon: All right. That's great. Well this is fascinating stuff. And I really appreciate you taking the time to talk to us today. This is great. Thank you.

Konrad Zmitrowicz: It was a real pleasure. Thanks a lot Sean.