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Australia’s Real Exchange Rate – Is it Explained by the Terms of Trade or by Real Interest Differentials?

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Author Info

  • David W.R. Gruen

    (Reserve Bank of Australia)

  • Jenny Wilkinson

    (Reserve Bank of Australia)

Abstract

We use time series techniques to examine the behaviour of Australia’s real exchange rate from 1969 to 1990. The real exchange rate exhibits non-stationary behaviour over this period, in contrast to simple purchasing power parity theory. We find weak evidence that the real exchange rate exhibits a stable long run relationship with the terms of trade. There is no stable long run relationship between the real exchange rate and either short or long real interest differentials between Australia and its major trading partners. Since the float of the Australian dollar and the world-wide deregulation of financial markets, we find some evidence that the real exchange rate exhibits a stable relationship with the terms of trade alone, and with long real interest differentials alone. The evidence for a stable relationship is clearest with long real interest differentials. After the float, we also find evidence that the terms of trade and long real interest differentials together help to explain the Australian real exchange rate. We estimate the number of independent long run relationships between the real exchange rate, the terms of trade and long real interest differentials and, for some specifications, find evidence of two independent relationships. Since the float, our best estimates are that a 1 per cent improvement in the terms of trade leads to an appreciation of the Australian real exchange rate of about 0.3 to 0.5 per cent, while an increase of 1 percentage point in the differential between Australian and world long real interest rates is associated with an appreciation of the Australian real exchange rate of about 2 to 3½ per cent.

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Bibliographic Info

Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9108.

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Date of creation: Sep 1991
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Handle: RePEc:rba:rbardp:rdp9108

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  1. Jeffrey D. Sachs, 1985. "The Dollar and the Policy Mix: 1985," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 117-197.
  2. Phillips, Peter C B & Hansen, Bruce E, 1990. "Statistical Inference in Instrumental Variables Regression with I(1) Processes," Review of Economic Studies, Wiley Blackwell, vol. 57(1), pages 99-125, January.
  3. Adrian Blundell-Wignall & Robert G. Gregory, 1990. "Exchange Rate Policy in Advanced Commodity-Exporting Countries: The Case of Australia and New Zealand," OECD Economics Department Working Papers 83, OECD Publishing.
  4. Frankel, Jeffrey A. & Meese, Richard, 1987. "Are Exchange Rates Excessively Variable?," Department of Economics, Working Paper Series qt18n4c5f6, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  5. Peter C.B. Phillips & Sam Ouliaris, 1987. "Asymptotic Properties of Residual Based Tests for Cointegration," Cowles Foundation Discussion Papers 847R, Cowles Foundation for Research in Economics, Yale University, revised Jul 1988.
  6. Phillips, P C B, 1987. "Time Series Regression with a Unit Root," Econometrica, Econometric Society, vol. 55(2), pages 277-301, March.
  7. Corbae, Dean & Ouliaris, Sam, 1991. "A Test of Long-Run Purchasing Power Parity Allowing for Structural Breaks," The Economic Record, The Economic Society of Australia, vol. 67(196), pages 26-33, March.
  8. Hooper, Peter & Morton, John, 1982. "Fluctuations in the dollar: A model of nominal and real exchange rate determination," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 39-56, January.
  9. Ball, Laurence, 1991. "The Genesis of Inflation and the Costs of Disinflation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 439-52, August.
  10. Meese, R. & Rogoff, K., 1988. "Was It Real? The Exchange Rate-Interest Differential Ralation Over The Modern Floating-Rate Period," Working papers 368, Wisconsin Madison - Social Systems.
  11. Blinder, Alan S, 1988. "The Fall and Rise of Keynesian Economics," The Economic Record, The Economic Society of Australia, vol. 64(187), pages 278-94, December.
  12. Jeffrey Sachs, 1985. "The Dollar and the Policy Mix: 1985," NBER Working Papers 1636, National Bureau of Economic Research, Inc.
  13. Clements, M.P., 1989. "The Estimation And Testing Of Cointegrating Vectors: A Survey Of Recent Approaches And An Application To The U.K. Non-Durable Consumption Function," Economics Series Working Papers 9979, University of Oxford, Department of Economics.
  14. Dornbusch, Rudiger & Fischer, Stanley, 1980. "Exchange Rates and the Current Account," American Economic Review, American Economic Association, vol. 70(5), pages 960-71, December.
  15. Frankel, Jeffrey A, 1979. "On the Mark: A Theory of Floating Exchange Rates Based on Real Interest Differentials," American Economic Review, American Economic Association, vol. 69(4), pages 610-22, September.
  16. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  17. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  18. Matthew T. Jones & Jenny Wilkinson, 1990. "Real Exchange Rates and Australian Export Competitiveness," RBA Research Discussion Papers rdp9005, Reserve Bank of Australia.
  19. Adrian Blundell-Wignall & Marilyn Thomas, 1987. "Deviations From Purchasing Power Parity: The Australian Case," RBA Research Discussion Papers rdp8711, Reserve Bank of Australia.
  20. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
  21. Pagan, Adrian R & Wickens, M R, 1989. "A Survey of Some Recent Econometric Methods," Economic Journal, Royal Economic Society, vol. 99(398), pages 962-1025, December.
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