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Asset market: Suppose the Canadian dollar interest rate (RCAD) is higher than the expected rate of return on US dollar deposits (ERORUSD). Will the Canadian dollar appreciate depreciate relative to the US dollar? Explain why.

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Answer #1

The US is Canada's biggest export market. That means Canada's fortunes are intrinsically linked to those of the US.

If the US Dollar rises, companies south of the border have more purchasing power to buy Canadian imports. That increases the flow of foreign money into Canada which, in turn, makes the Canadian Dollar strengthen too.

However, traders don't wait for the whole effect to play out. They know that US strength will lead to Canadian strength so, as soon as good news comes out in the US, the Canadian Dollar rises in anticipation of good times ahead north of the border.

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