Oil Prices, Exchange Rates and Interest Rates
46 Pages Posted:
Date Written: November 15, 2020
There has been much interest in the relationship between the price of crude oil, the
value of the U.S. dollar, and the U.S. interest rate since the 1980s. For example, the sustained
surge in the real price of oil in the 2000s is often attributed to the declining real value of the U.S.
dollar as well as low U.S. real interest rates, along with a surge in global real economic activity.
Quantifying these effects one at a time is difficult not only because of the close relationship
between the interest rate and the exchange rate, but also because demand and supply shocks in
the oil market in turn may affect the real value of the dollar and real interest rates. We propose a
novel identification strategy for disentangling the causal effects of traditional oil demand and oil
supply shocks from the effects of exogenous variation in the U.S. real interest rate and in the real
value of the U.S. dollar. Our approach exploits a combination of sign and zero restrictions and
narrative restrictions motivated by economic theory and extraneous evidence. We empirically
evaluate popular views about the role of exogenous real exchange rate shocks in driving the real
price of oil, and we examine the extent to which shocks in the global oil market drive the U.S.
real exchange rate and U.S. real interest rates. Our evidence for the first time provides direct
empirical support for theoretical models of the link between these variables.
Keywords: E43, F31, F41, Q43
JEL Classification: Exchange rate; market rate of interest; oil price; global real activity; commodity
Suggested Citation: Suggested Citation