The impact of oil price shocks on exchange rates: A non-linear smooth-transition approach

This paper contributes to the literature on the effects of oil price changes for developed and emerging oil-exporting countries by looking at the effects on real exchange rates, which affect a country’s terms of trade and hence its competitiveness. In contrast to previously used Markov-switching models where the adjustment process is abrupt and in a way a “black box,” we employ smooth transition models that specify the functional form of the adjustment process and are explicit about what variables drive the process. These types of smooth transition models have been successfully used to model the time series behaviour of exchange rate movements but have not yet been used to explain how exchange rates react to changes in oil prices, as far as we know. The paper considers logistic (asymmetric) and exponential (symmetric) smooth transition adjustments of real exchange rates for six major oil exporting countries in response to three different shocks affecting oil prices: an oil supply shock, an oil-market specific demand shock, and a global economic demand shock. Preliminary results for Canada only: We detect no statistically significant non-linearities, be they asymmetric or symmetric, for the effects of oil supply shocks and oil-market specific demand shocks on the exchange rate. Instead, the effects are linear in these cases. However, global aggregate demand shocks have non-linear effects on exchange rates.