The Canadian dollar, like the currencies of most industrialized nations, operates on the basis of a floating exchange rate, which means that the price of a Canadian dollar fluctuates according to market conditions. A floating currency is a key component of Canada's monetary policy framework, helping the economy to adjust to shocks and playing an important part in the transmission of monetary policy.
Neither the government nor the Bank of Canada target any particular level for the currency, believing that this should be determined by the market. Over time, the value of the Canadian dollar is determined by economic forces (fundamentals), such as the rate of inflation and the level of interest rates in Canada, which depend on the conduct of Canada's monetary policy, the growth of the Canadian economy, and the competitiveness of goods produced.
Policy on Foreign Exchange Intervention
Currency markets can be volatile, and the Bank of Canada may intervene in the foreign exchange markets on behalf of the federal government to counter disruptive short-term movements in the Canadian dollar. Any intervention is governed by an intervention policy, which is established by the government in close consultation with the Bank of Canada.
Prior to September 1998, Canada's policy was to intervene systematically in the foreign exchange market to resist, in an automatic fashion, significant upward or downward pressure on the Canadian dollar.1,2 In September 1998, the policy was changed because of the ineffectiveness of intervening to resist movements in the exchange rate caused by changes in fundamental factors. Canada's current policy is to intervene in foreign exchange markets on a discretionary, rather than a systematic, basis and only in the most exceptional of circumstances.
Intervention might be considered if there were signs of a serious near-term market breakdown (e.g., extreme price volatility with both buyers and sellers increasingly unwilling to transact), indicating a severe lack of liquidity in the Canadian-dollar market. It might also be considered if extreme currency movements seriously threatened the conditions that support sustainable long-term growth of the Canadian economy; and the goal would be to help stabilize the currency and to signal a commitment to back up the intervention with further policy actions, as necessary.
The Mechanics of Foreign Exchange Intervention
Foreign exchange market intervention is conducted by the Bank of Canada, acting as agent for the federal government, using the government's holdings of foreign currencies in the Exchange Fund Account3.
If the government and the Bank want to moderate a decline in the relative price of the Canadian dollar, the Bank will buy Canadian dollars in foreign exchange markets in exchange for other currencies, mainly U.S. dollars, which come from the Exchange Fund Account. This boosts demand for Canadian dollars and helps support the dollar's value. To make sure that the Bank's purchases do not take money out of circulation and create a shortage of Canadian dollars, which could put upward pressure on Canadian interest rates, the Bank "sterilizes" its purchases by redepositing the same amount of Canadian-dollar balances in the financial system.
Conversely, if the government and the Bank want to slow the currency's rate of appreciation, the Bank could sell Canadian dollars from its Canadian-dollar cash balances and purchase other currencies. By selling Canadian dollars, the Bank increases the supply of Canadian dollars in foreign exchange markets, and this provides some resistance to the upward movement in the currency. To "sterilize" the effect of the Bank's sales of Canadian dollars (and prevent downward pressure on Canadian interest rates), the same amount of Canadian-dollar balances are withdrawn from the financial system. The foreign currencies purchased when Canadian dollars are sold are added to the Exchange Fund Account.
When an intervention occurs, an announcement indicating the intervention is made on the Bank's Web site. The amount of the intervention undertaken is publicly available in the government's monthly official press release on international reserves.
2. From time to time, Canada participates with other countries in coordinated intervention. For example, on 22 September 2000, the Bank of Canada joined the European Central Bank, the Federal Reserve Bank of New York, the Bank of Japan, and the Bank of England in a concerted intervention to support the euro. This backgrounder deals exclusively with intervention directed at affecting movements in the Canadian dollar.
3. The Fund holds foreign reserves, such as U.S. dollars, Japanese yen, European euros, as well as other assets like Special Drawing Rights (SDRs) with the International Monetary Fund (IMF), and gold.