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Forecast of canadian exchange rate against US dollars in 2021...

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Fundamental Analysis of the Average Canadian exchange rate

against the US Dollars in 2021

FIN 3400 International Finance Submitted to : Professor Mei Li Submitted by : Eva Sukhija Student ID 1034296

Projected Forecast of Exchange Rate in the year 2021 In this report I have analyzed the implications of macroeconomic variables such as interests rates, oil prices and inflation rates on exchange rates by using different exchange rate determination theories such as Interest rate parity, Purchasing power parity, Relative purchasing power parity and modifying these theories whenever needed. Monetary policy and Fiscal policy implications on DD-AA model have also been evaluated to understand the exchange rate forecasts. Using these tools, I have projected that in 2021 the average exchange rate of Canadian Dollar against US dollar will decrease leading to an appreciation of Canadian dollar against US currency. I considered the individual inferences of interest rates, oil prices and inflation rates on exchange rates to understand its direct effect, while all else being fixed or constant and then I used the DD-AA model to understand the implications of global pandemic on the exchange rate of Canada against US dollars. Lastly, I concluded my findings at the end of the report with an appendix.

Interest Rates In this section, I explained how interest rates determine the exchange rates between a country by using the interest rate parity equation. I used the monetary policy and fiscal policies applied by the Bank of Canada (BoC) and Federal Reserve Board (Fed) in the United States (U.S) to determine the current interest rates. Based on my calculations of interest rates established by monetary policy I used the interest rate parity equation to determine the average change in the exchange rate in the future. The objective of Canada’s monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. (Poloz, S. August 13, 2020) The interest rate of Canada in the wake of the pandemic was determined by the inflation control target which in turn was determined by

prediction of future output growth, oil prices, and demand for exports. In the appendix, Chart 1 and Chary 2, the change in household spending patterns and CPI basket index has been shown respectively, in the year 2021. It is evident, that demand for essential products such as groceries, food, shelter has increased leading to increase in price. However, the spending on leisure activities/products such as restaurants, travel and transportation were severely reduced. This reduction has significantly outweighed the increase in prices for products that saw a surge demand resulting in CPI Inflation to fall sharply. Moreover, there is a significant decline in the output recorded by the central bank. As a result demand and supply both have fallen at the same time. This resulted in the level of output to fall by 15 percent compared to the fourth quarter of 2019. (Poloz, S. August 13, 2020) In these circumstances, BoC introduced expansionary monetary policy to save the economy from recession and to raise the inflation target to target 2 percent level by injecting money in the economy. The outcome or the effects of these decisions is predicted to take 6-8 quarters. Monetary policy used by Bank of Canada during the pandemic In the wake of these uncertain circumstances, the Bank of Canada reduced 1) its policy interest rate from 175 basis points to 25 basis points. and 2) launched a number of large-scale liquidity facilities and asset purchase programs through several channels and can be described as Quantitative Easing. Among various purchases 3) the bank has committed to continue buying at least $5 Billion of Canadian government bonds each week until the recovery. Bo C also 4) introduced credit easing programs and corporate bond purchasing programs to improve liquidity. The Fed’s monetary strategy in the U.S during the pandemic has been similar to the Canadian Monetary Policy strategy with the focus on increasing the inflation target level to 2 percent with achieving the other leg of its dual mandate, maximum employment. (Skidmore, D. August 13,2020) Monetary policy used by Fed during the pandemic

1)The Fed in the US has also reduced the policy interest rates to 0.25% with the objective of raising inflation to 2 percent level 2) The Fed increased its holdings of treasury securities to $500 billion and 3) its holdings of Agency MBS by $200 billion. (Federal Reserve Report, November 2020). (In the appendix a more detailed graph of purchase of assets by the US is highlighted, chart 3). Comparison between U.S and Canada Monetary Policy The Fed and BoC have used similar levels of policies such as reducing the target policy rate to 0.25 percent and purchasing of assets to create more liquidity in the economy. However, the size of these purchases is highly different. Economy of Canada is as large as the size of the Texas’s economy. It is quite evident from the monetary report that Canada only purchased approximately $5 billion of assets whereas BoC purchased $500 billion worth of treasury bills and additional assets. Therefore, the Bank of Canada’s balance sheet is not large compared with those of other major central banks, but the increase in its size has been particularly rapid. (Chart4). Fiscal Policy measures by Canadian Government Fiscal expansionary policies are established when the government increases its purchases or reduces its taxes. Canadian government spent 1) 0.9 percent of the GDP that is $20 billion on the health system to support vaccine, medical supplies. 2) around 11.6 percent of GDP in direct aid to households and firms which included wage subsidies for example CERB, employment insurance etc. 3) Lastly, Canadian government also deferred taxes of around $85 billion. Fiscal Policy by US Government U.S. government used 1)$44 billion from the Disaster Relief Fund to provide extra unemployment benefits, student loan payment relief, collections of employee social security payroll taxes and identify options to help renters and homeowners avoid evictions and foreclosures. 2) $483 billion was spent on Paycheck Protection Program and Health Care Enhancement Act for additional forgivable Small Business Administration loans and guarantees

to help small businesses that retain workers and 5 billion for expanding virus testing. 3)An estimated US$2.3 trillion (around 11% of GDP) on Coronavirus Aid, Relief and Economy Security Act (“CARES Act”) . The Act includes tax rebates to individuals, unemployment benefits, and provides a food safety net for the most vulnerable 4) An amount of $8.3 billion was spent on Coronavirus Preparedness and Response Supplemental Appropriations Act.

Applying interest parity equation to forecast individual effects of interest rates on exchange rates For trading purposes investors are primarily concerned about the expected rates of return on currency deposits. Investors want to decide whether to invest in Canada or the US based on determining the interest rate that Canadian and US economy earns. Investors calculate the expected rate of appreciation or depreciation of US currency relative to the domestic country to determine which economy offers more interest rate. This is why the interest parity equation is used. Rcad$ = RUS$ + (Ee$CAD/$US – E$CAD/$US) / E$CAD/$US On the right-hand side, we determine the rate of return on US deposits plus expected rate of appreciation or depreciation of US currency relative to Canadian currency and on the left-hand side we calculate the rate of return on Canadian deposits. Interest rate parity requires certain assumptions to follow such as: 1) demand for currency is solely determined by the expected rate of return and use 2) foreign exchange markets are in equilibrium if deposits of all currencies offer the same expected rate of return. However, to conduct my forecast I have modified the interest rate parity equation. I will be using: (Ee$CAD/$US – E$CAD/$US)/E$CAD/$US = Rcad$ - RUS$ equation to tell me the present case scenario and future scenario. On the left-hand side, I have expected a depreciation rate of Canadian dollars against US dollars which is calculated by the difference between Canadian interest rates and US interest rates. I will be looking into monetary policy applied by the Bank of

Canada and Fed to determine present interest rates in the economy because these interests rate will prevail in next year as economy is in liquidity trap and to get out of it new monetary policy is needed. Using Monetary policy to determine the changes in exchange rates After analyzing both the monetary policies we know that Rcad$ = 0.25% and RUS$ = 0.25%. This gives us the change in exchange rate in future to be constant as Rcad$ - RUS$ = 0. This tells us that the expected future exchange rate will be the same as the current exchange rate that is $0.76. This will lead to a liquidity trap where people will prefer holding cash than debts. To overcome this, banks must introduce monetary policies to shift the AA curve. It is evident that both the economies have used fiscal and monetary measures to help the economy revive. However, in my report applying Fiscal policy does not lead to exchange rate volatility in the upcoming year because the happenings in the next year shows a short-term effect and effects of fiscal policy will be effective in 2022-2023. Apart from that, the fiscal policy is a much-needed tool to bring out the economy from the shocks because it does not lead to exchange rate volatility. Hence in the year of 2021 the change in exchange rate will be constant and remain at average rate of $0.76 (current day’s exchange rate). Therefore, the effect of interest rate on the change in exchange rate is constant leading to neither depreciation nor appreciation of Canadian dollar against US dollars.

Oil prices In this section I determined how the oil prices affect exchange rates, considering all else equal. I have used purchasing power parity to understand this phenomenon. PPP is the idea that goods in different markets will cost the same in another country, once their exchange rate is applied. Purchasing Power parity Or Absolute PPP suggests: E$CAD = PCAD/PUS

The exchange rate between the two countries is the ratio of price levels of two countries. PPP suggests that all country’s price levels are the same when measured in the same currency. We know that if the prices of commodities in Canada rise relative to the prices in the US, it will lead to less demand for Canadian goods and more demand for US goods. This will lead to an increase in exchange rate as purchasing power of Canadian dollars will increase when prices are less in the United States compared to Canada. Therefore, more goods could be purchased for one Canadian dollar. To forecast whether the Canadian currency will appreciate or depreciate I have used data provided by the U.S. Energy Information Administration to estimate oil prices in 2021. According to the data, in 2020 the Canadian oil price is PCAD = $40.61(Brent Crude Oil) and U.S oil price is PUS = 38.34 (WTI Crude Oil). Thus, putting these values in Purchasing Power Parity equation we get: E$CAD = $40.61/$38.34 = 1.0526 I further calculated the exchange rate in 2021 using the future forecast of oil prices done by the U.S. Energy Information Administration. We get, E$CAD = $46.69/$44.24 = 1.04545 (Given PCAD = $46.69 and PUS = 44.24) Comparing the results from 2020 to 2021, exchange rate has reduced by approximately $0.02 that is 0.6% change in the exchange rate is forecasted. This suggests that in the future Canadian economy will appreciate. However, I have only used the basket of oil prices to project exchange rates in 2021, considering all else equal. Even though it has helped in providing direction of future exchange rates there are complications involved. For instance, the current exchange rate in the market for Canadian dollars against US dollars is $0.76 not $1.05 (as calculated above). This calculation does not take into account commodity prices for other baskets, interest rates or other variables resulting in only giving us an individual effect of variable oil prices on exchange rates.

Inflation rates Modifying Absolute PPP equation gives us another dynamic form that is Relative PPP. (E$/€,t – E$/€, t –1)/E$/€, t –1 = pUS, t – pEU, t Relative PPP is the percentage change in exchange rate in a period equal to the differential in inflation between the two countries over the same period. The theory suggests that countries with higher rates of inflation will have a devalued currency. For instance, if a country has a 10% rate of inflation in a given period then, that country will be able to purchase 10% less real goods in a year. To evaluate the implications of inflation rates on exchange rates, I have used the following data (Plecher. P, April 28, 2020) to calculate change in exchange rate in the year 2020 and projected change in year 2021. Years

2019

2020

2021

Inflation rates in Canada

1.95%

0.61%

1.26%

Inflation rates in U.S.

1.81%

0.62%

2.24%

Using the above Table above, I calculated that during the period of 2019-2020. The change in inflation rates in Canada and the US is -0.68% and -0.38% respectively. This tells us that in 2020 the change in exchange rate is -0.30%. On the other hand, in the year 2020-2021, the projected changes in inflation rates in Canada and the US are 1.06% and 2.61%. Applying Relative PPP we get, change in exchange rate to be -1.55% which is a further decrease from the change in year 2019-2020. This projected decrease in change in exchange rate tells us that in 2021 the currency will appreciate from its current level.

DD-AA Model to understand the combined effect of certain variables, fiscal and monetary policies on exchange rate.

DD schedule is determined by output market equilibrium. DD curve shows the combination of exchange rates at different output levels. It establishes output market equilibrium when aggregate demand = aggregate output such that: Y=D = C (Y – T) + I + G + CA (EP*/P, Y – T)

Factors that affect aggregate demand and lead to the shift of DD curve are changes in current account balance, government expenditures, consumption level, demand for domestic goods relative to foreign goods, investment decisions and price levels. The AA schedule is determined by two markets that is foreign exchange markets (R = R* + (Ee – E)/E ) and money market (Ms/P = L(R, Y) ) By equalizing foreign exchange market = money market we establish asset market equilibrium called AA schedule. A short term equilibrium is established when equilibrium in output market, money market and foreign exchange market holds, leading to the intersection of AA and DD schedule. The output market is in equilibrium at DD schedule and asset market is in equilibrium at AA schedule. For projecting the change in exchange rates using DD-AA schedule and its implications in 2021 following Assumptions are used: ●

Price level in foreign and domestic prices are fixed in the short term.

●

Monetary and fiscal policy of US do not impact the Canadian economy in the short run.

●

Monetary policy used in Canada does not completely revive the economy . Therefore, fiscal policy is needed to bring back the market at equilibrium.

Global Pandemic Implications on Exchange rate in 2021 1. First and foremost, we will notice changes in DD schedule. It is noticeable that DD curve shifts to DD1 and new equilibrium is established at point 2 from point 1. Why did this happen? This is one of the implications of the lockdown which resulted in a decrease in

current account balance to negative -13,216 (Moody’s Analytics, November 2020). The decrease in current account balance is due to less demand for exports by foreign markets under the lockdown rules globally and more imports of health and medical equipment and medicines.

2. Due to pandemic the output automatically decreases because lockdown does not allow producers to produce any output and they are unable to export goods at the same time, leading to the movement along the AA curve to reach at point 3. (Overshooting) 3.

During the lockdown, BoC projected that less output will be produced in the future and the exchange rate will depreciate, leading them to apply expansionary monetary policy to lower the interest rates and saving the economy from recession. It is evident that Monetary policy was applied by BoC in March when the lockdown was introduced. Since the monetary policy takes 6-8 quarters in showing short term changes. In the year of 2021, we will notice a shift in AA curve to point 4 decreasing the exchange rates and leading to average appreciation of the economy in the year of 2021.

4.

However, the economy has still not reached back to its original equilibrium output level that is point 5 and to realize the original output level expansionary fiscal policy used by Canadian government in May 2020 will start showing its effects with a rightward shift in DD curve to DD2 curve. Now the economy is at its original level of output with an appreciated Canadian dollar. However, this projected change will happen in subsequent years 2022-2023.

Conclusion In the year of 2021, I projected appreciation of Canadian dollar against US dollars. This projection is based on the individual effects of interest rates that lead to the zero percent change in exchange rate and future expected exchange rate to be equal to current exchange rate that is $0.76. Absolute PPP theory concluded, that by taking oil prices as an identical basket gave us the forecast of decrease in 2021 average level exchange rate to $1.04 from $1.05, leading to appreciation of Canadian dollar relative to the US dollar. Lastly, use of inflation rates in Relative PPP, gave us a negative change in exchange rate of -1.55% from -0.30 percent, again leading to appreciation of the currency. I further applied DD-AA model to understand the implications of monetary and fiscal policies which led to depreciation of currency at first(2020) and appreciating in the 2021 by applying monetary policy that will decrease the overshooting effect leading to an appreciation of currency.

Appendix: Chart 1 - Household Spending Patterns in Canada

Chart 2 - CPI Index

Chart 3 - Federal Reserve Purchases for Monetary Policy Strategy

Chart 4 - Central Banks total assets as percentage of their GDP

References :

Monetary policy canada : Poloz, S. (2020, August 13). Monetary Policy. Retrieved November 23, 2020, from https://www.bankofcanada.ca/core-functions/monetary-policy/ Monetary Policy Report – July 2020. (n.d.). Retrieved November 23, 2020, from https://www.bankofcanada.ca/2020/07/mpr-2020-07-15/ Monetary policy U.S. Skidmore, D. (2020, August 13). The Fed's review of its monetary policy strategy-and what Brookings' scholars have to say about it. Retrieved November 23, 2020, from https://www.brookings.edu/blog/up-front/2020/08/12/the-feds-review-of-its-monetarypolicy-strategy-and-what-brookings-scholars-have-to-say-about-it/ Federal Reserve Report (n.d.). Retrieved November 23, 2020, from https://www.federalreserve.gov/monetarypolicy/2020-06-mpr-part2.htm

Fiscal Policy Policy Responses to COVID19. (n.d.). Retrieved November 23, 2020, from https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19 Oil Prices U.S. Energy Information Administration - EIA - Independent Statistics and Analysis. (n.d.). Retrieved November 23, 2020, from https://www.eia.gov/outlooks/steo/marketreview/crude.php Inflation Rates Plecher, P., & 28, A. (2020, April 28). Canada - Inflation rate 1984-2021. Retrieved November 23, 2020, from https://www.statista.com/statistics/271247/inflation-rate-in-canada/

Current Account Balance Analytics, M. (n.d.). Canada - Current Account Balance. Retrieved November 23, 2...