Exchange rate fundamentals and the Canadian dollar

Views in the economic literature on the main factors that influence exchange rates have evolved over time in response to economic developments and new trends in economic theory. This article provides a brief interpretative survey of the main theories of exchange rate determination. The factors that influence exchange rate developments are varied and complex. However, the authors show that the broad movements of the Canada-U.S. real exchange rate since the early 1970s can be captured by a simple equation that highlights the role of commodity prices and Canada-U.S. interest rate differentials. The equation is used to interpret the evolution of the real exchange rate over the last two decades. At times, the real exchange rate deviates significantly from what the equation would predict. One explanation is that the equation omits certain factors that can influence the exchange rate, particularly in the short run. These may include fiscal policy variables, international indebtedness, political uncertainty, and investor sentiments -- factors that are difficult to quantify but that have been particularly relevant in recent years.