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This paper seeks to understand the extent of New Zealand's exchange rate fluctuations compared to others, and what drives New Zealand's exchange rate.
New Zealand has only experienced a limited number of exchange rate cycles since the dollar was floated. On a trade-weighted basis this paper finds that New Zealand has large exchange rate cycles, but that some other relevant economies (e.g. Australia, the Euro Area, Japan and South Korea) also have similarly large cycles. By comparing the short-term (i.e. month-to-month) volatility of New Zealand's exchange rate to other economies, on a trade-weighted basis New Zealand's exchange rate fluctuates greatly. New Zealand, Australia and Japan face the highest levels of short-term volatility out of the economies included in the analysis.
Factors that affect the expected relative return on New Zealand dollar assets are found to explain a significant part of exchange rate cycles. These include interest rate differentials between New Zealand and other countries, relative growth performance and attitudes to risk. More fundamental drivers such as export commodity prices and the terms of trade, and productivity growth also drive New Zealand dollar returns. The main driver of the exchange rate changes over time in response to developments in the domestic and global economy.
The author would like to thank Mark Blackmore, Anne-Marie Brook, John Janssen, Paul Gardiner, Michael Reddell and Renee Philip for their substantial input at various stages in the preparation of this paper.
The views, opinions, findings, and conclusions or recommendations expressed in this Working Paper are strictly those of the author. They do not necessarily reflect the views of the New Zealand Treasury. The Treasury takes no responsibility for any errors or omissions in, or for the correctness of, the information contained in this Working Paper. The paper is presented not as policy, but to inform and stimulate wider debate.
Table of Contents
- 1 Introduction
- 2 Framework
- 3 Evidence on exchange rate volatility and variability
- 3.1 Short-term (month-to-month) volatility
- 3.2 Medium-term variability
- 4 Drivers of the exchange rate
- 4.1.2 Domestic drivers
- 4.2 Equilibrium level
- 5 Conclusion
- 6 References
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