Academic journal article The European Journal of Comparative Economics

The Oil Price and Exchange Rate Relationship Revisited: A Time-Varying VAR Parameter Approach

Academic journal article The European Journal of Comparative Economics

The Oil Price and Exchange Rate Relationship Revisited: A Time-Varying VAR Parameter Approach

Article excerpt

1. Introduction

1.1 Context

Since the beginning of the 1970s, foreign exchange and oil markets both sustained shocks and crises. With the unilateral cancellation of the direct convertibility of the US Dollar to gold on August 15, 1971, the world economy experienced a new financial context with the advent of a floating foreign exchange market. In 1976 the Jamaica Agreement replaced defacto the Bretton Woods System based on exchange rate stability. In the oil markets, the progressive take-over by the Organization of the Petroleum Exporting Countries (OPEC), at the beginning of the 1970s, and the first oil shock in 1973-1974 can be considered as the starting point of a new context of oil price volatility compared to the previous decade. As oil is quoted in US dollars (henceforth, USD), the oil prices and the value of the dollar seem to have a mutual influence and it is relevant to study the interaction between those two variables. Several studies have previously investigated the link between the USD and the oil prices.

1.2 Literature Review

Krugman (1980, 1983) analyses the variation of the USD following an oil price increase in a model with three different areas (America, Germany and the OPECmembers). He demonstrates that the final effect on the Dollar exchange rate in the short run heavily depends on the comparison between the US weight in world oil imports and the share of Dollar assets in OPEC's portfolio; while in the long run, the comparison has to be made between the US share in world oil imports and the weight of US goods in OPEC's imports. Golub (1983) divides the world in three areas (America, Europe and the OPEC countries) and two currencies (USD and Deutsche Mark) and focuses on the wealth transfers to the OPEC countries. Under the assumption of inelastic demand of oil from Europe and America, the USD depreciates against the German currency if the OPEC countries have a higher propensity to hold Deutsche Marks than the oil-importing countries. If, as a result of the wealth transfer, there is an excess demand for Deutsche Mark, then the dollar exchange rate will depreciate.

There is no clear consensus in the literature concerning the direction (influence of the dollar on the oil price or vice versa) and the sign of the relationship between oil price and the value of the Dollar (e.g., Beckmann and Czudaj, 2013). Regarding the direction of the relationship, some studies focused on the oil price to exchange rate causality. Chen and Chen (2007) investigate the long-term relationship between the real oil prices and the real exchange rate. Using a panel data methodology, they find a cointegration relationship using a set of different markers of crude oil or basket price (Brent, Dubai, West Texas Intermediate (WTI) and world prices), and conclude that the oil prices are "the dominant source of real exchange rate movements". However, Sadorsky (2000) and Krichene (2007) among others find a reverse causality from USD to oil prices. Therefore, the direction of the causality between oil price and exchange rate is not clear cut. Percebois (2009) summarizes the complexity of the relationship by emphasizing the possibility of a bilateral causality through various macroeconomic channels such as: the effect on world demand through local prices, a Chinese effect, a petrodollar recycling effect, and a target revenue effect. Benassy-Quere et al. (2007) highlight the existence of a cointegration relationship between the oil price and the Dollar real effective exchange rate for the 1974-2004 period with the causality link running from oil price to the exchange rate. Nevertheless, the authors suggest that the causality link could be reversed in the 2002-2004 period because of the Chinese monetary policy. Benhmad (2012), using wavelet analysis, also emphasized that time scales matter. Causality between real oil price and real effective US Dollar exchange rate returns runs in bidirectional ways in long time horizons, while in short time horizons, causality runs from oil prices to real effective US Dollar exchange rate returns. …

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