CHAPTER For funds to be transferred from one country to another, they have to be converted from the currency in the country of origin (say, dollars) into the currency of the country to which they are going (say, euros) The foreign exchange market is where this conversion takes place and it is instrumental in moving funds between countries It is also important because it is where the foreign exchange rate, the price of one country s currency in terms of another s, is determined Because the foreign exchange rate is the relative price of two national currencies, there are two ways of quoting an exchange rate: either as the amount of domestic currency that can be purchased with a unit of foreign currency or as the amount of foreign currency that can be purchased with a unit of domestic currency Throughout this book, we always use the latter quoting convention that is, we express the exchange rate as units of foreign currency per Canadian dollar In these terms, when the exchange rate increases so that a Canadian dollar buys more units of foreign currency, we say that the Canadian dollar has had an appreciation A decline in the exchange rate is associated with a depreciation of the Canadian dollar Figure 1-8 shows the exchange rate for the Canadian dollar from 1971 to 2008 in terms of the U.S dollar The exchange rate is defined as the U.S dollar price of one Canadian dollar Clearly, the exchange rate has experienced five long swings over this period The first is a 30.8% depreciation from January 1973 to February 1986; the second is a 26.0% appreciation from February 1986 to January 1992; the third is a 26.7% depreciation from January 1992 to October 2002; the fourth is a 62% appreciation from October 2002 to November 2007; and the fifth is a 21% depreciation from November 2007 to January 2009 What have these fluctuations in the exchange rate meant to the Canadian public and businesses? A change in the exchange rate has a direct effect on Canadian consumers because it affects the cost of foreign goods In particular, a weaker dollar leads to more expensive foreign goods, makes vacationing abroad more expensive, and raises the cost of indulging your desire for imported delicacies When the value of the dollar drops, Canadians decrease their purchases of foreign goods and increase their consumption of domestic goods (such as travel within Canada) Conversely, a strong dollar means that Canadian goods exported abroad will cost more in foreign countries and foreigners will buy fewer of them Exports of steel, for example, declined sharply when the dollar strengthened in the late 1980s 1.1 US $/Can $ Exchange Rate 1.0 0.9 0.8 0.7 F I G U R E 1- Exchange Rate for the Canadian Dollar, 1971 2008 Source: Statistics Canada CANSIM II Series V37426 2009 2007 2005 2003 2001 1999 1997 1995 1993 1991 1989 1987 1985 1983 1981 1979 1977 1975 1973 0.6 1971 The Foreign Exchange Market Why Study Money, Banking, and Financial Markets? 11