Are exchange rates absorbers of global oil shocks? A generalized structural analysis

Abstract

This paper studies the impact of global oil market shocks on the level, volatility, and correlation dynamics of real effective exchange rates over time. We find that the USD and the EURO act as shock absorbers, as shocks to the global oil market explain substantial proportions of the volatility and correlation dynamics of each exchange rate – compared to the small or even negligible contributions of exogenous interest rate and effective exchange rate shocks. Further we find an interesting “puzzle” that the Euro Area unexpectedly behaves as if it were an oil exporting country - the EURO appreciates in response to a flow demand shock that increases oil price. Our findings are garnered from a generalized time-varying SVAR model with stochastic volatility that allows for correlated disturbances between observation and transition equations and among transition equations themselves. This approach of enriching dynamics between the first and second moments of endogenous variables is particularly suitable for capturing the transmission of structural level oil shocks to the volatility of exchange rates and their correlation with the global oil market.