The relationship between the Australian dollar and the macroeconomic fundamentals.

Abstract

This paper examines the link between the Australian dollar’s exchange rate (A$) to US dollar (US$) and Australia’s terms of trade. By using a simple econometric model, with the terms of trade as the sole explanator, the US$/A$ rate is found to be cointegrated with the terms of trade and the relationship between the two variables appears to be robust. Our estimate of the long run elasticity of the exchange rate with respect to the terms of trade is 0,775, which strongly supports the widely held view that the floating A$ is a “commodity currency”. An estimated error-correction model describes how the short term dynamics are linked to the long-term relationship, leading the cointegrating relationship to equilibrium. The causality of the variables is proven to be bilateral, running significantly from the terms of trade to the exchange rate but less significantly from the exchange rate to the terms of trade.