Oil prices and the rise and fall of the US real exchange rate

https://doi.org/10.1016/S0261-5606(98)00004-7Get rights and content

Abstract

Questions of the relative importance of real vs. monetary shocks in explaining exchange rate movements still have no widely accepted answer, despite their importance both for the research agenda and for policy questions. We examine this issue using a variety of empirical techniques for the US effective exchange rate. We find that a stable link exists between oil price shocks and the US real effective exchange rate over the post-Bretton Woods period. The results suggest that oil prices may have been the dominant source of persistent real exchange rate shocks and that energy prices may have important implications for future work on exchange rate behavior.

Section snippets

Data description and cointegration results

The data we use are monthly observations of the real effective (i.e. trade-weighted) value of the US dollar and US real price of oil over the 1972.2–1993.1 sample period. The real US dollar effective exchange rate is defined in terms of the currencies of 15 other industrial countries and deflated by wholesale price indices, as calculated by Morgan Guaranty. The oil price series is the US dollar spot price of West Texas Intermediate Crude Oil deflated by the US consumer price index. Both

Causality results

In this section we investigate the issue of causality. From Engle and Granger (1987), we know that cointegration implies that at least one of our two variables must Granger-cause the other (bi-directional causality is also a possibility). Understanding the apparent causal relationship in the data is interesting both for econometric and economic reasons.

On the econometric side, Granger-causality has important implications for inference and for evaluating the accuracy of conditional forecasts.

An error-correction model

In this section we determine how well the dynamic process generating the US real exchange rate can be captured by a single-equation error-correction model (ECM). According to the Engle and Granger (1987)Representation Theorem, the presence of cointegration in a system of variables implies that a valid error-correction representation exists. This theorem together with the evidence of weak exogeneity found above suggests that we can use a single equation error-correction representation without

Can we forecast exchange rate changes?

In Section 2we established the strong exogeneity conditions required to perform valid out-of-sample forecasting comparisons. Therefore we now consider the ECM's ability to forecast out-of-sample exchange rate changes. First, we follow the methodology used by Meese and Rogoff (1983)and compare the out-of-sample forecasts produced by the ECM to those generated by a random walk. Specifically, we begin by estimating the specifications on data up to 1985.12 and then generating forecasts for all

Understanding the effect of oil price shocks

Our analysis has established the presence of a long-run relationship between the real exchange rate and oil prices, found that causality runs from oil prices to the real exchange rate and not vice versa, and developed a stable single equation representation of the relationship that has significant ability to predict exchange rate changes out-of-sample. In this section, we turn our attention to the sign of this long-run relationship.

While the United States is a major importer of both crude oil

Conclusions

We have explored whether a link exists between the price of oil and the US real exchange rate. The results presented above show that the US real exchange rate appears to be cointegrated with the real price of oil, which suggests that oil prices may have been the dominant source of persistent real shocks over the post-Bretton Woods period. Causality tests also indicate that causality runs only from oil prices to exchange rates and not vice versa. The single-equation ECM relating these two

References (57)

  • C Adams et al.

    Structural models of the dollar

    IMF Staff Pap.

    (1991)
  • Amano, R.A., van Norden, S., 1992. Unit-root tests and the burden of proof. Working paper 92-7, Bank of Canada, Ottawa,...
  • Amano, R.A., van Norden, S., 1993. Oil prices and the rise and fall of the US real exchange rate. Working paper 93-15,...
  • D.W.K Andrews

    Tests for parameter instability and structural change with unknown change point

    Econometrica

    (1993)
  • D.W.K Andrews et al.

    An improved heteroscedasticity and autocorrelation consistent matrix estimator

    Econometrica

    (1990)
  • D.K Backus

    Empirical models of the exchange rate: Separating the wheat from the chaff

    Can. J. Econ.

    (1984)
  • D.K Backus et al.

    International real business cycles

    J. Pol. Econ.

    (1992)
  • Boughton, J.M., Haas, R.D., Masson, P.R., Adams, C., 1986. Effects of exchange rate changes in industrial countries....
  • J Burbidge et al.

    Testing for the effects of oil-price rises using vector autoregressions

    Int. Econ. Rev.

    (1984)
  • J.Y Campbell et al.

    The dollar and real interest rates

    Carnegie–Rochester Conf. Ser. Public Pol.

    (1987)
  • G Canarella et al.

    Cointegration between exchange rates and relative prices: another view

    Eur. Econ. Rev.

    (1990)
  • Y.Y Chong et al.

    Econometric evaluation of linear macro-economic models

    Rev. Econ. Stud.

    (1986)
  • Clarida, R.H., Gali, J., 1994. Sources of real exchange rate fluctuations: how important are nominal shocks? Working...
  • D.A Dickey et al.

    Distributions of the estimators for autoregressive time series with a unit root

    J. Am. Stat. Assoc.

    (1979)
  • M Dotsey et al.

    Oil shocks, monetary policy and economic activity

    Fed. Res. Bank Richmond Econ. Rev.

    (1992)
  • R.F Engle et al.

    Co-integration and error correction: Representation, estimation and testing

    Econometrica

    (1987)
  • R.F Engle et al.

    Exogeneity

    Econometrica

    (1983)
  • Finn, M.G., 1991. Energy price shocks, capacity utilization and business cycle fluctuations. Discussion paper 50,...
  • Cited by (378)

    • Impacts of bitcoin on monetary system: Is China's bitcoin ban necessary?

      2024, Research in International Business and Finance
    View all citing articles on Scopus
    1

    We are grateful to Alain DeSerres for his work on an earlier draft and to John Murray and Isabelle Weberpals for their comments and suggestions. An earlier version of this article was presented under the title `The determinant(s) of the US real exchange rate' at the 1993 Canadian Economic Association Meetings, Ottawa, Ontario, Canada. We acknowledge the use of the Bank of Canada's RATS test procedures. The responsibility for errors is ours. Opinions expressed here are ours and do not necessarily reflect those of the Bank of Canada or its staff.

    View full text