Modelling the US$/A$ Exchange Rate Using Cointegration Techniques

Recent evidence indicates that Australia's real effective exchange rate, its terms of trade and a long-term real interest rate differential form a cointegrating relationship. This paper uses this evidence to analyse the nominal US$/A$ exchange rate. The US$/A$ rate is found to be cointegrated with the terms of trade and relative price levels. However, interest rate differentials appear to add nothing to this long-run relationship. Estimated error correction models suggest that there is a substantial two-way relationship between nominal exchange rate changes and changes in the terms of trade. This evidence indicates that the small, open-economy assumption of exogenously given terms of trade may be inappropriate when modelling movements in the US$/A$ exchange rate. Changes in a long-run interest rate differential, possibly reflecting differences in expected inflation rates, contribute significantly to an explanation of short-run changes in the nominal exchange rate.