Canadian Securities Course (CSC) Level 1 Practice Exam

How do foreign interest rates and exchange rates affect interest rates in Canada?

1. They have no impact on Canadian interest rates

2. They cause Canadian interest rates to decrease

3. An increase in foreign investments weakens the value of the Canadian dollar, leading to higher interest rates

4. Lower foreign interest rates strengthen the value of the Canadian dollar, lowering interest rates

The correct answer is: An increase in foreign investments weakens the value of the Canadian dollar, leading to higher interest rates

The relationship between foreign interest rates, exchange rates, and Canadian interest rates is rooted in the interplay of capital flows and currency valuations. When foreign interest rates rise, it often attracts investments to those countries, which can lead to a decrease in demand for Canadian assets. This reduced demand can weaken the Canadian dollar. A weaker Canadian dollar can lead to higher inflationary pressures, prompting the Bank of Canada to raise interest rates to combat inflation, which is captured in the dynamics described in the chosen answer. In this context, when there's an increase in foreign investments, it can lead to a situation where the Canadian dollar depreciates. This depreciation can contribute to inflation, which usually leads to higher interest rates as the central bank responds to maintain price stability. Hence, the correct choice accurately reflects the cascading effect of foreign interest rates and currency strength and their subsequent business implications on domestic interest rates in Canada.