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