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

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.