TERMS OF TRADE AND REAL EXCHANGE-RATES - THE CANADIAN EVIDENCE

This paper presents empirical evidence linking the Canada-US real exchange rate with the terms of trade. Using recently developed econometric methods for non-stationary data we find that the real exchange rate is cointegrated with terms-of-trade variables, and that causality runs from the terms of trade to the exchange rate. We then construct a simple exchange rate equation that satisfies several specification tests and performs better than a random walk in post-sample forecasting experiments. The results suggest that much of the variation in the real exchange rate is attributable to movements in the terms of trade and that the influence of monetary factors is secondary, (JEL F31). This paper presents empirical evidence linking the Canada-US real exchange rate with the terms of trade. Using recently developed econometric methods for non-stationary data we find that the real exchange rate is cointegrated with terms-of-trade variables, and that causality runs from the terms of trade to the exchange rate. We then construct a simple exchange rate equation that satisfies several specification tests and performs better than a random walk in post-sample forecasting experiments. The results suggest that much of the variation in the real exchange rate is attributable to movements in the terms of trade and that the influence of monetary factors is secondary.