The commodity currency puzzle
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Date
2005Metadata
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- Discussion Papers [1002]
Abstract
Abstract:
This paper addresses the purchasing power parity (PPP) puzzle for commodity currencies. A
substantial part of the literature on commodity currencies has found that, despite controlling for the
effect of commodity prices, PPP does not hold in the long run. We show that once we also control for
the effect of the interest rate differential in the real exchange rate relationship, the discrepancies from
PPP are fully accounted for. The analysis is applied to the real exchange rate behaviour in Norway,
which has a primary commodity (oil) that constitutes the majority of its exports. We show that with the
interest rate differential included in the long run real exchange rate relationship, the real oil price
plays a minor role. Adjustment to equilibrium (half-lives) is also substantially reduced, taking no more
than one year on average. Hence, contrary to earlier findings on commodity currencies, we have
effectively removed the PPP puzzle.
Keywords: Exchange rate, commodity currencies, real oil price, purchasing power parity, uncovered
interest parity.