What Drives Exchange Rates? New Evidence from a Panel of U.S. Dollar Bilateral Exchange Rates

TLDR: In this paper, the authors identify the factors that have been driving a panel of exchange rates of industrialized countries using both a principal factor and a state-space model, and decompose the historical variation in each of the real U.S. dollar bilateral exchange rates.

Abstract: We use a novel approach to identify the factors that have been driving a panel of exchange rates of industrialized countries. Using both a principal factor and a state-space model we identify two common in‡uences in a panel of six of U.S. bilateral real exchange rates: Australia, Canada, the euro, Japan, New Zealand and the United Kingdom. We link the …rst common factor to macroeconomic shocks in the United States and the second to world commodity prices. Using these two factors, we decompose the historical variation in each of the real U.S. dollar bilateral exchange rates. We …nd a strong role for U.S. factors in explaining the pattern of exchange rate developments over the 2002 to 2007 period. A smaller, although still signi…cant, role is found for commodity prices. In the case of Canada, we also …nd an important role for the improvement in the Canadian …scal situation in explaining the strength of the Canadian dollar, relative to the U.S. dollar. Domestic economic developments were also found to be quite important for explaining the weakness of the Japanese Yen.