What Drives Exchange Rates? New Evidence from a Panel of U.S. Dollar Bilateral Exchange Rates
AbstractWe use a novel approach to identify economic developments that drive exchange rates in the long run. Using a panel of six quarterly U.S. bilateral real exchange rates – Australia, Canada, the euro, Japan, New Zealand and the United Kingdom – over the 1980-2007 period, a dynamic factor model points to two common factors. The first factor is driven by U.S. shocks, and cointegration analysis points to a long-run statistical relationship with the U.S. debt-to-GDP ratio, relative to all other countries in our sample. The second common factor is driven by commodity prices. Incorporating these relationships directly into a state-space model, we find highly significant coefficients. Then, we decompose the historical variation of each exchange rate into U.S. shocks, commodities, and a domestic component. We find a strong role for economic fundamentals: Changes in the two common factors, which are driven by the (relative) U.S. debt-to-GDP ratio and commodity prices, can explain between 36 and 96 per cent of individual countries' exchange rates in our panel.
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Bibliographic InfoPaper provided by Bank of Canada in its series Working Papers with number 10-5.
Length: 36 pages
Date of creation: 2010
Date of revision:
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Exchange rates; Econometric and statistical methods;
Find related papers by JEL classification:
- J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-02-13 (All new papers)
- NEP-BEC-2010-02-13 (Business Economics)
- NEP-CBA-2010-02-13 (Central Banking)
- NEP-IFN-2010-02-13 (International Finance)
- NEP-MON-2010-02-13 (Monetary Economics)
- NEP-OPM-2010-02-13 (Open Economy Macroeconomic)
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- Domenico Ferraro & Kenneth S. Rogoff & Barbara Rossi, 2012.
"Can Oil Prices Forecast Exchange Rates?,"
NBER Working Papers
17998, National Bureau of Economic Research, Inc.
- Domenico Ferraro & Ken Rogoff & Barbara Rossi, 2011. "Can Oil Prices Forecast Exchange Rates?," Working Papers 11-05, Duke University, Department of Economics.
- Ferraro, Domenico & Rogoff, Kenneth & Rossi, Barbara, 2011. "Can Oil Prices Forecast Exchange Rates?," CEPR Discussion Papers 8635, C.E.P.R. Discussion Papers.
- Domenico Ferraro & Ken Rogoff & Barbara Rossi, 2011. "Can oil prices forecast exchange rates?," Working Papers 11-34, Federal Reserve Bank of Philadelphia.
- Jun Nagayasu, 2013. "Co-movements in real effective exchange rates: evidence from the dynamic hierarchical factor model," Working Papers 1318, University of Strathclyde Business School, Department of Economics.
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