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What drives exchange rates? New evidence from a panel of US dollar bilateral exchange rates

Bank of Canada Ottawa
Publication Date
  • J31
  • Ddc:330
  • Exchange Rates
  • Econometric And Statistical Methods
  • Wechselkurs
  • Öffentliche Schulden
  • Volkswirtschaft
  • Us-Dollar
  • Australien
  • Kanada
  • Neuseeland
  • GroßBritannien
  • Europäische Wirtschafts- Und Währungsunion
  • Japan
  • Economics


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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