How is the value of a dollar measured? Well that depends on what one wishes to do with a dollar!

We might wish to buy a dollar, we might wish to borrow a dollar, or we might wish to buy something with a dollar. The cost of each of these activities changes over time, and we measure these changes with three different rates. These are 1) exchange rates, 2) interest rates, and 3) inflation rates. 

The situation becomes somewhat complicated when we realize that a change in any one value of the dollar will influence the other values of the dollar. Thus, we observe constant activity in the value of the dollar - as each value is constantly responding to changes in the other values.

This is a hyperlinked diagram. Just click on the parts you wish to examine.

$ / FCUnit

Loosely translated, this means that the exchange rate will be calculated by taking what you give, and dividing it by what you get. For example, if you give one Canadian dollar and only receive $0.65 American dollars, then the exchange rate will be 1.54 - meaning that it will cost us $1.54 to buy one American dollar. The exchange rate plays a particularly important role in the Canadian economy because, compared with other countries, imports and exports represent a relatively large part of Canada's economic activity.

How a Change in Inflation Will Effect the Exchange Rate:

If a country is experiencing high inflation, then that country’s currency becomes extremely unattractive to foreign investors. For one thing, the price of goods or service in that country will be expensive. For another thing, the purchasing power of the currency is dropping - it might not be able to buy tomorrow what it could buy today!

Thus, the decrease in demand for this particular currency will cause that currency to drop in value on the international currency market. Fortunately, the opposite is also true. If a country has very low inflation, then that country's currency is a secure investment. Thus, more foreign investors will be attracted to the currency, and the high demand for the currency will drive its price up on the international currency market.

How a Change in the Exchange Rate Will Effect Inflation:

If a country's exchange rate drops (in other words, if its currency becomes worth less on the international currency market) then that country will likely experience an increase in inflation. This is because it will now cost more of that country's currency to purchase imports. If the importers must pay more, then the increase in prices will be passed on to the consumer.

Fortunately, the opposite is also true. If a currency increases in value, then importers will not have to spend as much money in order to import goods into the country, and those savings will be passed on to the consumer.

How a Change in Interest Rates Will Effect the Exchange Rate:

If a country is experiencing high interest rates, then that country’s currency becomes more attractive to foreign investors. For one thing, these investors are more assured that inflation in that country will be controlled by the higher interest rates. Secondly, investors may even wish to purchase the currency simply as an investment, and collect the high interest on the currency later on.  

Unfortunately, the opposite is also true. If a country has very low interest rates, then that country's currency is not very attractive to foreign investors. These investors will not be assured that inflation is being controlled, nor would they be as willing to purchase the currency as an investment, because the interest they could collect on the currency would be lower. 

How a Change in the Exchange Rate Will Effect Interest Rates:

This is a complex relationship to analyze. A country's Central Bank may choose to respond to a drop in their currency's exchange rate (in other words, a drop in its currency's value on the international currency market) or they may choose not to respond. This is a subjective decision, and the Central Bank would have to closely examine the issue of why their currency is dropping in value.

However, one can be fairly assured that if a currency dropped too far on the currency market, then the Central Bank will eventually increase interest rates, as higher interest rates will generally attract foreign investment in a currency. 

Naturally, the opposite is true. If a country's exchange rate increased, the Central Bank may respond with a decrease in interest rates, or they may choose to postpone this decision. 

How a Change in Inflation Will Effect Interest Rates:

If a country is experiencing high inflation, then that country will have to increase its interest rates. There is no choice in this matter, as money lenders will have to ensure that the interest they collect on their loans is greater than the rate of inflation - otherwise the money they are paid back will not be able to buy what it could at the time they loaned it out!

Fortunately, the opposite is also true. If a country has very low inflation, then that country will reduce its interest rates in order to entice consumers to borrow money.

How a Change in Interest Rates Will Effect Inflation:

If a country is experiencing high interest rates, then that country’s rate of inflation will eventually drop. There are three major reasons why this is true, and they are realted to a decrease in spending. Firstly, higher interest rates will persuade consumers to start saving their money in order to collect the higher interest rates. Secondly, higher interest rates will discourage consumers from borrowing money, which will mean that spending on "big ticket" items, such as homes, cars, furniture and appliances, will decrease. Finally, an increase in interest will strengthen the currency's exchange rate, and thus the country will be able to import foreign goods for less money.

Unfortunately, the opposite is also true. If a country has very low interest rates, then that country's will eventually start to experience an increase in inflation. This is due to the fact that low interest rates would not encouraged people to save their money, the low cost of loans would encourage people to borrow money for "big ticket" items, and the country's currency would likely drop in value - thus increasing the cost of imported goods.