The Relationship between Oil Prices, Exchange Rates and Interest Rates
By Lutz Kilian, Ph.D., Senior Economic Policy Adviser, Federal Reserve Bank of Dallas and Member of the JPMCC’s Research Council and Xiaoqing Zhou, Ph.D., Economist, Federal Reserve Bank of Dallas
This digest article discusses how modeling the relationship between oil prices, exchange rates and interest rates raises some interesting identification challenges. Recent research shows how the workhorse structural oil market VAR model may be modified to overcome these challenges. The resulting structural model sheds light on common conjectures about the determinants of the variability of the real exchange rate, the real price of oil, and the U.S. real interest rate. The model estimates provide a more nuanced understanding of historical oil price fluctuations, but substantively agree with earlier historical narratives.
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