Testing the Relationship between Domestic Factors and Real Exchange Rate in China

In this study, we mainly investigate how the domestic factors of China (trade openness, Kaopen, real interest rate, real government consumption and real GDP) affect the real exchange rate using Ridge regression and the VAR model from 1970-2015. The empirical results show, in the short run, that positive real government consumption, real interest rate and trade openness lead to a real exchange rate depreciation in both models, while the real GDP and Kaopen lead to a real exchange rate appreciation in Ridge regression. After ten-year lags are used in the VAR, we find that the negative effects of real government consumption and real interest rate shocks are small on impact in the long run, but the Trade Openness shocks and Kaopen shocks have strong negative effects on the real exchange rate in the long run. The real GDP shocks keep a strong positive effect on the real exchange rate in the long run