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How can a country manipulate its currency?

For example: Canada actively purchases US dollars in an effort to control the US/Canadian rate.

What are the ways Canada can use purchased USD to benefit the Canadian dollar?

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By buying USD, the Canadian government reduces the number of USD in the money supply, thus making the USD rarer and so more valuable compared to the CAD.

This dollar buying also increases the number of USD in its own central bank, and that increases the "national value" of Canada, which increases the value of its own currency; however it can mitigate this, if it wishes to have a cheaper currency than the USD, by simply printing more.

To answer the broader question, there are many ways a country can manipulate its currency:

  • Increase the "money supply"; the total number of units of currency in production. Several ways to do this, depending on the money structure of the government in question. The US Fed has four main tools; it can lower the Federal Funds Rate (the rate at which banks borrow from the Fed, making money cheaper and more easily spent), lower the Interbank Rate (the rate at which FDIC member banks must lend to each other; similar effect), lower the reserve requirement (the percentage of total deposited assets which banks must keep in cash), and increase government bond buying, funding the excess by printing new money and giving it to the Treasury to spend.
  • Decrease the money supply. The same four controls can be moved in the opposite direction, having the opposite effect.
  • Make something of value that gives you a competitive advantage. The more that other countries, and their people and companies, want something that only you can make, the more valuable your currency will become.
  • Buy another country's currency and either sit on it or destroy it (for fiat currency, the slip of paper is the thing of value, and while national laws typically prohibit its citizens intentionally destroying money, it definitely happens inside and outside the country's borders). This decreases that country's money supply, increasing the value of a unit of its currency.
  • Back your country's currency with something of value, making a unit of currency worth some defined but movable fraction of a unit of the commodity or security. This can be done by explicitly buying a commodity ("a Kabuki is worth exactly 1/1000 of one Troy ounce of gold", or "A Kabuki is worth exactly US$0.25"), or tacitly through price fixing of exports (if Kabukistan had cornered the market on almonds, for instance, and the government forced growers to sell one kilo of almonds for 5 Kabukis, then the value of one Kabuki is pretty much that of 200 grams of almonds, and its value compared to other currencies adjusts based on the demand for almonds).
  • "Peg" your currency's value to that of another currency. This can be done by "backing" your currency with the other currency as in the above point, or by fiat; countries like China, in which the State owns all of the financial institutions allowed to operate in the country, can force those banks to trade their currency at some defined rate, regardless of market forces. Until mid-2010, Chinese yuan (Renmin B) were exchanged at 6.8RMB = 1USD by definition, with other countries' currencies exchanged at rates based on this one. Based on differences in standard and cost of living, and what a Yuan would buy in China compared to a dollar in the U.S., this ensured that Chinese currency was always cheaper than dollars, decreasing the price of Chinese goods relative to American in the global market. However, since the financial collapse, China has let its currency float more freely against the dollar for a variety of reasons (not the least of which being that the US was hopping mad about this state of affairs, and the USD was weakening so much that China started having trouble paying for imports from Europe and Russia with the RMB being pegged to the USD's value).
  • Thanks for the explanation. could you tell me how can a country "Back" it's currency with a commodity or security or another country's currency? – user793468 Sep 23 '13 at 20:43
  • The "gold standard" is a historically common example of a commodity-backed currency; a U.S. dollar was, as late as the Depression, equatable by statute to a specific fraction of a Troy ounce of gold. Silver was also commonly used both as currency in itself and as a backing for paper money in many countries including the U.S. Ever hear of a "silver dollar"? Until the 20th century, they really were silver (not always pure though). – KeithS Sep 23 '13 at 21:24
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    There are several problems with a "metal specie" standard (coin money, minted with the actual precious metal giving it its value). One is that, to have money, you have to have the precious metal; you can't simply "create money", as the Fed and other central banks currently do, to stimulate spending by making money cheaper than what it will buy. – KeithS Sep 23 '13 at 21:36
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    As for a currency being "backed" by another type of currency, this is typically achieved with a "currency board"; an agency of the central bank that literally buys the foreign currency and keeps it in vaults as a store of value against which it issues a known fixed quantity of domestic currency. See the Wikipedia link for current and historical examples of currency boards backed by Dollars, Pounds Sterling and Euros. – KeithS Sep 23 '13 at 21:38
  • @KeithS Pedantic point: in reference to your last bullet point, I always thought the term was "peg" the currency, not "pin" the currency. I've always heard that countries who maintain a fixed exchange rate relative to another currency are pegging their exchange rate. – John Bensin Oct 3 '13 at 19:47
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By purchasing USD, the Canadian government influences the USD/CAD exchange rate, lowering the value of the CAD (providing more supply of it in exchange for the USD it's buying). Lower value of CAD means Canadian-sourced imports are cheaper. Thus, US importers have incentive to buy from Canada.

  • CAD depreciates in value just because Canada bought USD with CAD? – user793468 Sep 20 '13 at 16:28
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    Yes, because there are now fewer USD in circulation, and as Canada probably printed CAD to buy USD, there are more CAD in circulation, reducing their value. – KeithS Sep 20 '13 at 18:33
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This question is built on a faulty premise. It's impossible to manipulate a single exchange rate like USD1 to CAD2 without affecting other exchange rates.

This is because of arbitrage; the fact that both currencies can be exchanged into a third currency. Here's a simple example explaining why:

Let's say that the USD is trading at parity to the CAD; they both have the same value. And let's say that a USD (or CAD) is worth 0.7 EUR3.

Assume that the United States government starts buying CAD and selling USD. Let's assume that they buy enough CAD so that one CAD buys 1.05 USD.

That has to affect all exchange rates, otherwise you could transfer your USD into EUR, and then into CAD and magically4 make money. Arbitrage5 prevents this from happening.

In general Currency Manipulation occurs through:

1) Raising interest rates to encourage people to buy your currency so that they can earn a high rate of return.
2) Intervention into the foreign current markets buying/selling a currency.
3) One of the purest forms of manipulation is threatening to intervene. Here's an example in Japan.

1. United States Dollar
2. Canadian Dollar
3. Euro
4. One USD is worth 0.7 EUROS which is worth one CAD which is worth 1.05 USD.
5. In this example arbitrage would be exchanging USD -> EUR -> CAD -> USD and making 5% on every dollar.

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