Oil Prices and the Rise and Fall of the U.S. Real Exchange Rate

We examine whether a link exists between oil price shocks and the U.S. real effective exchange rate. The results show that the two variables appear to be cointegrated and that causality runs from oil prices to the exchange rate and not vice versa. The single-equation error-correction model linking these two variables is stable and captures much of the in- and out-of-sample movements in the exchange rate in dynamic simulations. Finally, tests we present show that the error-correction model has signficant post-sample predictive ability for both the size and sign of changes in the real effective exchange rate. The results suggest that oil prices may have been the dominant source of persistent real exchange rate shocks over the post-Bretton Woods periods and that energy prices may have important implications for future work on exchange rate behaviour.