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What Drives Exchange Rates? New Evidence from a Panel of U.S. Dollar Bilateral Exchange Rates

  • Jean-Philippe Cayen
  • Donald Coletti
  • Rene Lalonde
  • Philipp Maier

We 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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Paper provided by Bank of Canada in its series Staff Working Papers with number 10-5.

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Length: 36 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bca:bocawp:10-5
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