Modeling the Australian Dollar–US Dollar Exchange Rate Using Cointegration Techniques

This paper examines the link between the Australian dollar’s exchange rate and Australia’s terms of trade. The US$/A$ rate is found to be cointegrated with the terms of trade, and the relationship between the two variables appears to be robust. An estimated error‐correction model for changes in the nominal US$/A$ is shown to have reasonable out‐of‐sample predictive powers. Weak exogeneity tests within the Johansen framework indicate highly significant causality running from the terms of trade to the exchange rate but less significant causality running from the exchange rate to the terms of trade.