NAFTA and sources of real exchange rate fluctuations in North America

Exchange rate shocks are among those that can threaten economic growth sustainability especially in countries where exports constitute a considerable portion of its GDP. Theoretical literature conveys that exchange rate is assumed to be subject to two types of disturbances: real shocks (e.g., supply and demand shocks) and nominal shocks (e.g., monetary shocks). It is expected that these shocks cause fluctuations in the real exchange rate. It is also expected that exchange rate behaves differently if the country is more engaged in free trade. Hence, this paper seeks to empirically investigate the influence of North American Free Trade Agreement (NAFTA) on the sources of real exchange rate fluctuations in the USA and Canada. The paper employs a structural vector autoregression (SVAR) model, which characterises this joint behaviour of the exchange rate and assumes long-run neutrality of nominal shocks. The results suggest that the sources of the real exchange rate volatility in the USA and Canada have been changed because of the increase of the bilateral trade and investment between both countries.