Determinants of the real exchange rate in a small open economy: Evidence from Canada

• Published in: Journal of international financial markets, institutions & money Vol. 23; pp. 163 - 178
• Main Author: Kia, Amir
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01.02.2013; Elsevier Science Ltd
• Subjects: Canada; Commodity prices; Debt; Deficit and foreign financing; Economic theory; Exchange rates; Foreign exchange rates; GDP; Gross Domestic Product; Interest rates; Monetary policy; Monetary theory; Money supply; Public expenditure; Real exchange rate; Studies; U.S.A; Canada; F41; F40; Debt; Real exchange rate; F31; Deficit and foreign financing; Monetary policy
• ISSN: 1042-4431; 1873-0612
• DOI: 10.1016/j.intfin.2012.09.001

► We developed a real exchange rate model for a small-open economy. ► The model was tested on Canadian data for the period 1972–2010. ► It was found that the model performs very well in both long and short runs. ► None of the domestic fiscal variables has any statistically significant impact on the growth of the real exchange rate over the short-run. ► The change in interest rate and the growth of the money supply have a negative impact on the growth of the real exchange rate. This study develops a theoretical monetary model of the real exchange rate and shows that over the long run the real exchange rate is a function of real money supply, domestic and foreign interest rate, real GDP, real government expenditure, deficit per GDP, domestic and foreign outstanding debt per GDP, domestic and foreign externally financed debt per GDP and commodity price. The model was tested on Canadian data (1972Q1–2010Q3 period). It was found that all variables, except real money supply, domestic and foreign interest rate and domestic externally financed debt have a statistically significant impact on the real exchange rate in Canada. However, the domestic fiscal variables do not have any impact on the real exchange rate over the short run. The change in interest rate, the growth of money supply, the commodity price and the US debt per GDP have a negative impact on the growth of the real exchange rate over the short run.