Modelling the Australian Dollar

This paper outlines an error correction model (ECM) of the Australian dollar real trade-weighted index (RTWI), which is one of the approaches used by Reserve Bank staff as a starting point for thinking about the level of the exchange rate. This particular model is designed to help answer a specific question, namely: What is the level of the exchange rate that would be expected to prevail over the medium term based on the exchange rate's historical relationships with other theoretically and empirically relevant variables? Notwithstanding the well-documented difficulties in empirically modelling exchange rates, the ECM has displayed robust explanatory power for a number of decades, in large part due to the strong historical relationship between Australia's terms of trade and the real exchange rate. That said, it is still worth considering whether two recent unusual economic forces – namely, Australia's resources boom and the adoption of unconventional monetary policy by several major foreign central banks – have been adequately captured by the model. With this purpose in mind, the paper also discusses several extensions to the ECM. Overall, these extensions provide little evidence that the relationships between the RTWI and its historical determinants have changed substantially over time. While there is some evidence that unusual economic forces did contribute to the exchange rate being somewhat higher in recent years than would otherwise have been the case, we do not find compelling evidence of omitted variables that have substantially influenced the exchange rate over a longer period of time.