RDP 9108: Australia's Real Exchange Rate – Is it Explained by the Terms of Trade or by Real Interest Differentials? 1. Introduction

As part of the deregulation of Australia's financial markets, the Australian dollar was floated in December 1983. The real exchange rate^[1], after having been roughly steady since the mid-1970s, depreciated by about 35 per cent between the beginning of 1984 and mid-1986. Over the rest of 1980s, about two-thirds of this very large depreciation was unwound.

Many have argued that movements in the Australian real exchange rate are substantially influenced by shifts in the terms of trade (see, for example, McKenzie (1986), Blundell-Wignall and Thomas (1987), Simes (1988), Blundell-Wignall and Gregory (1990), Freebairn (1989) and Murphy and Smith (1991)). As these studies recognise, in a small open commodity exporting economy such as Australia's, the real exchange rate should shift in response to movements in real fundamentals such as the terms of trade.

Another strand of literature (see, for example, Sachs (1985), Dornbusch and Frankel (1987), Isard (1988), Meese and Rogoff (1988) and Blundell-Wignall and Browne (1991)) has attempted to explain movements in the real exchange rates of large OECD countries by real interest differentials. In a world with deregulated financial flows, it is consistent both with sticky-price monetary models such as the Dornbusch (1976) overshooting model and with portfolio-balance models such as Branson (1979) that real exchange rates should be correlated with real interest differentials.

In this paper we assess empirically whether, over the time periods we consider, Australia's real exchange rate is explained by the terms of trade, by real interest differentials, or by a combination of the two. We use time series techniques to address these issues and focus on whether stable long run (so-called cointegrating) relationships exist between all or a subset of these variables.

Footnote

We use the term “real exchange rate” to mean the nominal exchange rate adjusted for differences in the price level (which we measure by the Consumer Price Index) between between Australia and its trading partners. It is thus an “external” measure of the real exchange rate rather than the relative price of non-traded to traded goods, as implied by the Swan-Salter definition of the real exchange rate. Dwyer (1987) examines the relationship between these two measures of the real exchange rate. [1]