Real Exchange Rate Determinants in the Industrialised Commodity Currency Economies: An error-correction framework

Abstract: Although located at far-flung points of the globe, Australia, Canada, Iceland, New Zealand and Norway have an intrinsic similarity and together represent an anomaly in international macroeconomics; they are the industrialised commodity currency economies. These five nations have advanced and developed while maintaining their traditional dependence on primary resources, thereby exposing the value of their respective currencies to the volatility of global commodity price cycles. There is increasing discourse in these countries regarding the desirability of this feature. This thesis takes a step back from this debate and employs an error-correction framework to investigate whether exogenous shocks to the commodity terms of trade are indeed a fundamental determinant of the long-run equilibrium real exchange rate. I find that the influence of commodity prices on the Australian and New Zealand dollars evidenced in previous studies has continued throughout the 1999-2005 commodity price boom. Conversely, in Canada there appears to have been a fundamental shift in the nature of the relationship during the past decade. In the first study to apply this framework to Iceland and Norway, I find that the model only performs well for Iceland after the float of the króna, and that the Norwegian krone exhibits a non-linear relationship with the price of oil. Overall the message is clear: the real price of the commodity exports of each of these countries continues to be a fundamental determinant of the real exchange rate.