The impact of world oil price shocks on the Canada/U.S. real exchange rate

ABSTRACT

This article investigates whether and how changes in the world oil price affect the Canada/U.S. real exchange rate. We applied vector autoregression and vector error correction models for the real exchange rate, world oil price, monetary differential, government spending, and productivity differential between the two countries. Our results demonstrate that a surge in the world oil price will lead to an appreciation of the Canadian dollar in the short and long term. Product differentials and U.S. government spending have a negative impact on the Canada/U.S. real exchange rate, and Canadian government spending leads to a depreciation of the Canadian dollar.

KEYWORDS:

• Canada/U.S.
• real exchange rate
• vector autoregression model
• vector error correction model
• world oil price

Acknowledgment

We are very grateful for the constructive comments of Dr. Kathleen M. Day (Department of Economics, University of Ottawa) for this project.

Notes

¹ IFS employment data for Canada (EMINd) only cover the period from 1993 Q1 to 2003 Q1. Therefore, we replaced these data with the number of persons employed in Canada from CANSIM (Table 2820087, Series v2062811). Because the CANSIM data are monthly but the IFS data are quarterly, we converted the CANSIM data to a quarterly series by taking the average for each quarter. Then, we scaled the CANSIM data to convert it from thousands to millions of people to make it consistent with the IFS series.

² For variance decomposition, EViews 5 computes Monte Carlo standard errors with 100 repetitions.

³ The likelihood ratio tests are carried out at the 5% level of significance.

⁴ We also ran the same analyses with the Canada/U.S. nominal ER. However, the cointegration test suggested that there is no long-term effect of the world oil price on nominal ERs (both the Trace test and maximum eigenvalue test indicate that there is no cointegration at the 0.05 level for nominal ER and for log real ER). Therefore, we focus on the real ER for VAR and VEC models in this article.

⁵ Given that the focus of this article is on RER, we will present only the responses of RER. The responses of other variables are available upon request.

⁶ 2015 Oil Exports and Imports Summary, by the Canada National Energy Board. Accessed on May 5, 2017 from https://www.neb-one.gc.ca/nrg/sttstc/crdlndptrlmprdct/stt/crdlsmmr/2015/smmry2015-eng.html.