Foreign Exchange Fund and the Open Foreign Exchange Markets
The Foreign Exchange Fund owned by the Government and used to defend or alter the value of
the Canadian Dollar is left over from a period of more active defence of exchange values. In the
present context, there is a more market-based orientation allowing the exchange rates to seek
values set by real market forces rather than attempt to hold or defend values that may be based on
more artificial evaluations.
The Use of the Fund in a Fixed Exchange Rate Regime
To simply, we will assume that there are two currencies used in trade, the Canadian Dollar and
the British Pound. In addition, the market for pounds will be assumed to be located in Canada
and the market for the Canadian Dollar is located in the UK. In actual fact the two markets
would be simultaneously taking place in both countries, with a real world interaction with all the
other currencies used in trade. In our simplified context, the demand for pounds in Canada
requires the offer of Canadian Dollars, a willingness to supply dollars. Using the same logic, a
demand for CDN Dollars in the UK requires the offer or supply of Pounds. The supply of one
currency is the demand for the other.
In the case of a Fixed Exchange Regime a value is selected and is maintained by Government
Sales and purchases designed to satisfy any excess demands for a currency by augmenting supply
and to collect any excess supply of a currency by purchasing them. Figure one below shows a
situation where the original equilibriums are under pressure due to changes in market conditions
or through the actions of speculators.
Figure One: Excess Demand for the Pound and an Excess Supply of Dollars
In the Diagram on the Left-hand side, the price axis shows the dollar price of one pound sterling.
On the Right-hand side, the price axis shows the pound price of one dollar.
In Diagram 1, an excess demand for the pound has developed at the exchange rate of $2.00
equalling one pound in Canada. This creates an excess Supply of Dollars in the UK at half a
pound to buy a dollar. If the excess demand for the pound and the excess supply of the dollar are
not closed, the exchange rate for the pound will increase and the pound price of the dollar will
fall below the target set of $2 to buy one pound and .50 parts of the pound to buy one dollar.
This is where the Foreign Exchange Fund would come in. The fund would Supply sufficient
pounds to satisfy the excess demand for the pound in the Pound Market while buying up the
excess supply of dollars at the set exchange rate in the dollar market. If this action is successful,
the fixed exchange rates will hold. A problem could develop since the Fund and the Bank of
Canada are not able to manufacture pounds to sell. The ability to hold the exchange rate is
dependent on the available supply of pounds in the Fund’s inventory. As a result, short term
defences are the only ones likely to be mounted where there is a realistic expectation that the
forces creating the need for an exchange rate change will abate after the Fund takes action.
However, if there was a desire to go on with the defence on a longer term basis, additional
pounds would have to be obtained. The Canadian Government could offer Bonds denominated
in pounds and sell them in the UK to obtain additional pounds to sell. Currency Swaps between
Central Banks and/or Governments could be undertaken. As a final resort, the pounds could be
borrowed from the International Monetary Fund. However, this last step is likely to be avoided
since repeated borrowing from the IMF will only take place if the country agrees to external
guide lines intended to correct monetary policy and fiscal policy. Rather than Borrow Pounds to
sell in a case of Fundamental Disequilibrium, the Fund would let the exchange rate adjust to a
more defendable level.
The purchase of dollars by the Fund can have monetary repercussions depending on where the
dollars bought are currently located and where they go. This is true whether there is a fixed
exchange rate regime or a managed float system. Under a managed float, the market forces set
the rates with some adjustment by the Government to make a more orderly transition to a new
value. In a free market float, the exchanges of currency normally will not involve the
Government. However, if the Government is involved, the trail of the dollars is important in
assessing any impact on the money supply. If the dollars are currently in a Canadian Chartered
Bank and remain there, the purchase will change the name of the owner without monetary
impact. The Government Fund will now own the Dollar balances while the previous owner
surrenders ownership. If the dollars are outside the country and are repatriated as a result of the
purchase, there is a potential for an increase in the domestic supply of available money provided
that the dollars are placed in a Chartered bank. If the purchase moves the dollars into the Bank of
Canada or they move there as a mater of policy, the dollars no longer exist unless the dollars are
redeposited back into the chartered banks. To see if there is any monetary impact by foreign
exchange purchases, the trail of the dollar must be followed. The pound is not part of this
process since it can’t be used in the course of ordinary transactions in Canada.
Figure Two: Excess Demand for the Dollar and an Excess Supply of Pounds
In Figure Two the Dollar Market is experiencing an excess demand for dollars which is resulting
in an excess supply of pounds in the Pound Market at the fixed exchange rate of $ 2 to buy one
pound and .50 parts of a pound to buy one dollar. If these pressures are not handled, the
exchange rate will change. The dollar price of a pound will fall, while the pound price of a dollar
will increase. To hold the set value, the fund will have to buy the excess pounds and supply the
excess demand for of dollars. Since the Bank of Canada is the manufacturer of the Dollar, this
defence is not necessarily limited by a supply problem since dollars needed for the defence can
be borrowed from the central bank. However, if this borrowing process were to be carried to
excess, the base would expand as more dollars were created by the monetising of the
Governments IOU’s. A more likely limit would be set by the available supply of dollars already
in Government hands and a reasoned policy concerning their use to defend against an increase in
the pound price of one dollar.
The monetary impact of these sales of dollars has to be assessed by looking at where the dollar is
now and where it goes. If there is expanded borrowing from the central bank, the sale of these
borrowed dollars will increase the domestic money supply unless the dollars are moved out of the
country. The more likely outcome would be one where the new dollars will move into the
chartered banks in Canada. Since a Canadian dollar with few exceptions can only earn interest
and make purchases of earning assets in Canada, it will in all likelihood remain in Canada no
matter who owns it. If the Dollars being sold already exist and are located in the chartered banks
in Government Deposits and the new owner places them back into the chartered banks, there is
no impact on the money supply. If the dollars being sold are currently in the Government’s
Demand Deposit Account in the central bank, as the dollars flow out the domestic money supply
will increase unless additional action is taken to draw down funds in the chartered banks to
rebuild the Dg account and offset the monetary expansion.
A Few Notes on the Diagrams in Figures One and Two
The diagrams use a flat demand curve and supply curve to represent the actions of the Fund as
dollars or pounds are offered. This flat form is indicating an infinite willingness to buy or sell
currency at the specified rate. This form of function is appropriate where there is a fixed price
that the Government seeks to maintain. If the Government is willing to accept other values, the
whole Demand Curve or Supply Curve could shift out at any of these prices to represent the
supplementary Demand or Supply provided by Government.