The Commodity Price and Exchange Rate Dynamics

Abstract

This paper investigates the dynamic relationship between the commodity price and the exchange rate in Australia and New Zealand. We focus on Australia and New Zealand. Not only do their primary commodities account for significant shares of their exports, but also their currencies share some distinctive characteristics that are unique from other commodity currencies. Using country-specific commodity price indices, we examine the relationship between the departure of currency value from its fair value and fundamental macroeconomic variables. Evidence of a strong and robust relationship between the exchange rate and the commodity price has been found. Results indicate that the commodity price can be used to improve the forecast ability of the future exchange rate. Our commodity-price-augmented exchange rate forecasting model consistently outperforms the random-walk model, for both in-sample and out-of-sample forecasting. These results shed some extra lights on policymaking for countries that rely on primary commodity production, and attempt to move towards floating exchange rate regimes as part of their global market liberalization process.

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