Oil Prices, Exchange Rates and Interest Rates

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See all articles by Lutz Kilian

Lutz Kilian

Federal Reserve Banks - Federal Reserve Bank of Dallas; Centre for Economic Policy Research (CEPR)

Xiaoqing Zhou

Federal Reserve Banks - Federal Reserve Bank of Dallas

Date Written: November 15, 2020

Abstract

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

Kilian, Lutz and Zhou, Xiaoqing, Oil Prices, Exchange Rates and Interest Rates (November 15, 2020). CFS Working Paper, No. 646, 2020, Available at SSRN: https://ssrn.com/abstract=

Lutz Kilian (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Xiaoqing Zhou

Federal Reserve Banks - Federal Reserve Bank of Dallas ( email )

2200 North Pearl Street
PO Box 655906
Dallas, TX 75265-5906
United States

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