Academic journal article
By Korhonen, Iikka; Juurikkala, Tuuli
Journal of Economics and Finance , Vol. 33, No. 1
Published online: 23 October 2008
© Springer Science + Business Media, LLC 2008
We assess the determinants of equilibrium real exchange rates in a sample of oil-dependent countries. Our data cover OPEC countries from 1975 to 2005. Utilising pooled mean group and mean group estimators, we find that the price of oil has a clear, statistically significant effect on real exchange rates in our group of oil-producing countries. Higher oil price lead to appreciation of the real exchange rate. Elasticity of the real exchange rate with respect to the oil price is typically between 0.4 and 0.5, but may be even larger depending on the specification. Real per capita GDP, on the other hand, does not appear to have a clear effect on real exchange rate. This latter result contrasts starkly with many earlier papers on real exchange rate determination, emphasising the unique position of oil-dependent countries.
Keywords Equilibrium exchange rate * Pooled mean group estimator * Resource dependency
JEL codes F31 * F41 * P24 * Q43
We focus in this paper on how the real price of oil affects the equilibrium exchange rate of countries where the dominant export product is oil. As oil and related products constitute practically the sole source of export revenue for most of the countries examined here, oil prices can be inferred to affect terms of trade and the real exchange rate. In addition, the real price of oil has been quite volatile during recent decades, so we should expect to see large macroeconomic effects from oil price changes in these countries.
We consider a sample of nine Organization of the Petroleum Exporting Countries (OPEC) members that depend heavily on exports of oil, natural gas and oil products. The empirical analysis uses a sample extending from 1975 to 2005.
In the empirical analysis we do not rely on any one theory of exchange rate determination, but instead adopt Behavioural Equilibrium Exchange Rate (BEER) approach, where a number of plausible variables are introduced as determinants of real exchange rate. In our application the relationship of these variables with the real exchange rate is assessed with the help of panel co-integration methods. Our preferred method is the pooled mean group (PMG) estimator proposed by Pesaran et al. (1996), but we also employ a mean group estimator.
In our estimation framework the real oil price has a direct effect on the equilibrium exchange rate, and, more importantly, oil price is the only variable with a consistent and statistically significant effect on real exchange rate in our sample of oil-producing countries. While coefficient estimates differ from one estimation to another, they tend to cluster around 0.5 (in some specifications the coefficient may be even larger). In other words, a 10% increase in the real price of oil leads to appreciation of about 5% in the equilibrium exchange rate of a typical oil-producing country.
The study is structured as follows. In the next section, we provide a short literature survey on the topic. We then assess the time series properties of our data. "Section 4" provides our main econometric analysis and "Section 5" concludes.
2 Literature survey
Under our definition, an increase in real exchange rate index means depreciation. We first compare the bilateral real exchange rate of our sample of oil-dependent countries against the US dollar. We also consider the real effective exchange rate (REER) calculated as a weighted average of individual bilateral real exchange rates. The weights here represent the shares of different countries in the home country's foreign trade. In our empirical application, REER is defined so that upward movement means appreciation.
A number of studies discuss the determinants of equilibrium exchange rates in developing or emerging market countries (e.g. Baffes et al. 1997; Edwards 1989, 1994; Montiel 1999). …