Role of Supply Shocks in Real Exchange Rate Fluctuations: The Inclusion of Commodity Price Shocks

Abstract

This paper seeks to elucidate the role of supply shocks in real exchange rate fluctuations by including industrial input commodity price shocks as an additional type of supply shock alongside the typically studied technology or productivity shocks. Building upon the framework of Gehrke and Yao (2016), we utilize a six-variable structural vector autoregressive (SVAR) model identified with long-run zero restrictions and sign restrictions to study four countries: the US, the UK, Japan, and Korea. Generally, we find that supply shocks overall contribute significantly to real exchange rate volatility and persistence. In particular, commodity price shocks are very influential in some instances, highlighting the importance of including this additional type of supply shock in the analysis. Given that the majority of existing studies contend that supply shocks play a small role in real exchange rate fluctuations, this study makes an important contribution to the literature by incorporating an influential yet often omitted type of supply shock and providing evidence that supply shocks play an important role. Our findings are supported by variance decompositions in both the time domain and the frequency domain. Replacing industrial input commodity prices with the oil price alone produces similar results. Monetary policymakers that try to influence exchange rates should be wary of supply shocks, including commodity price shocks.