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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, René Lalonde and Philipp Maier ()

Staff Working Papers from Bank of Canada

Abstract: 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.

Keywords: Exchange rates; Econometric and statistical methods (search for similar items in EconPapers)
JEL-codes: J31 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2010
New Economics Papers: this item is included in nep-bec, nep-cba, nep-ifn, nep-mon and nep-opm
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