The Effect of Inflation Differential on the Nominal Exchange Rate: The Case of USA and Canada



Year of publication 2016
Type Article in Proceedings
Conference Proceedings of the 15th International Conference on Finance and Banking
MU Faculty or unit

Faculty of Economics and Administration

Field Economy
Keywords inflation differential; nominal exchange rate; time series; VAR
Description Macroeconomists from all over the world have always been interested in the influence of the inflation differential on the nominal exchange rate. This research paper focuses on the application of inflation differential theory to the US economy and one of its main trading partners - Canada. The primary aim of this paper was to prove that inflation differential affects the nominal exchange rate of the American dollar to the Canadian dollar. Secondary aim was to determine whether inflation differential and exchange rate depend on their previous values. This task was fulfilled by usage of VAR approach, which is considered to be standard econometric tool for stationary time series analysis. It was found out that inflation differential depends on its previous value, while exchange rate does not. Selected approach turned out to be unable to prove or disprove that inflation differential affects USD/CAD exchange rate. More variables should have been included in regression analysis, because inflation differential alone is not sufficient to explain changes in USD/CAD exchange rate.
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