In our previous blog back in May, we took a dive into the relationship between inflation and interest rates, recognizing how these factors impact our everyday lives. However, there’s more to the economic puzzle than just those two pieces. Picture this: you’re planning your winter escape to the sun-soaked beaches of Miami. As you plan, you might realize that the value of your Canadian dollars against the US dollars at different times can either make or break your vacation budget. This intricate dance of values, known as exchange rates, lies at the heart of our interconnected world, shaping economies and influencing decisions on a global scale.
We inhabit an era of a highly interdependent world economic system. Since the aftermath of World War II, the international trade in goods and services has steadily increased. Canadian businesses are seeking markets for their products and services across borders, while also sourcing raw materials and skilled labor from every corner of the world. Meanwhile, Canadian consumers are able to enjoy products from various international sources.
Similarly, with financial fluidity, we benefit from a seamlessly integrated global financial market. The integration allows Canadian savers to purchase German government bonds or shares in US companies, while Canadian investors can find opportunities to finance projects in London, as well as in Toronto.
At the heart of this global dance lies the notion of exchange rates. Exchange rates determine how much one currency can be exchanged for another. Consider the Canadian dollar (CAD) and the US dollar (USD). With a recent exchange rate of around 0.75, 1 CAD fetches you 0.75 USD. However, these rates are far from set in stone. They float under the influence of various economic forces. The value of the CAD once surpassed the USD back in the early 2000s, courtesy of a robust Canadian economy, however, Canada needs to remain a lower dollar value to compete with neighbors as an exporting economy.
But exchange rates do not hold all the answers. Let’s say you’re told that the exchange rate between the Canadian dollar and the Japanese Yen is 78 Yen per Canadian dollar. Sounds like a bargain, right? Not so fast. It’s important to note that everyday goods and services might have dramatically different price tags in different countries due to varying economies. For instance, in Japan, where even though you can get a lot of Yen for a single Canadian dollar, the actual cost of commodities is measured in hundreds or thousands of Yen.
To truly make sense of the global prices, we need to consider not just the exchange rate but also the actual cost of goods. For instance, if a hamburger in Halifax costs you three Canadian dollars, and the same burger in Tokyo costs 312 Yen (with an exchange rate of 78 Yen per CAD), you might think you’re getting a steal in Tokyo. However, when you factor in that 78 Yen equals one Canadian dollar, that Tokyo burger is equivalent to four Canadian dollars, and suddenly seems a lot less attractive. In essence, this comparison unveils the real exchange rate, providing a more accurate sense of the price of domestic goods relative to foreign ones.
Now, it’s easy to assume that identical goods should lead to identical prices across the globe, assuming no transportation and other administrative costs. However, reality paints a different picture. The Economist magazine has invented the Big Mac Index, or Burgernomics, to track the price of Big Mac hamburgers in different countries. While a Big Mac is largely the same no matter where you order it, the prices vary significantly. Take Britain, where a Big Mac costs 4.19 British Pounds, and contrast that with the 5.58 US Dollars you’d need in the United States. This indicates a real exchange rate of 0.75 British Big Macs per US Big Mac, even though the spot exchange rate hovers around 0.78 British Pounds per US Dollar. This indicates that the British Pound is potentially undervalued by about 3.4% in terms of the commodities it can buy.
In conclusion, exchange rates are far more than just numbers on a screen. They embody the intricate interplay between currencies, economies, and the choices we make in our interconnected world. As we move forward to our next blog, we will introduce how exchange rates are determined using a supply-and-demand analysis, the approach most frequently employed by economists.
