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Title:What drives exchange rates? New evidence from a panel of US dollar bilateral exchange rates PDF Logo
Authors:Cayen, Jean-Philippe
Coletti, Donald
Lalonde, René
Maier, Philipp
Issue Date:2010
Series/Report no.:Bank of Canada Working Paper 2010,5
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.
Subjects:Exchange rates
Econometric and statistical methods
JEL:J31
Document Type:Working Paper
Appears in Collections:Bank of Canada Working Papers

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