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&quotThisthesis was written as a part of the master programme at NHH. Theinstitution, the supervisor, or the examiners are not – through theapproval of this thesis – responsible for the theories and methodsused, or results and conclusions drawn in this work.&quot


Fora long time, studies have sought to find a relationship between theimpact of the exchange rate on the export and import of goods andservices (Harri, Nalley, and Hudson 2009). The results of theseinvestigations have revealed that exchange rates have a significantimpact on the prices of the commodities that are traded in a country.However, energy also impacts the production of goods and servicessignificantly. The use of products such as petroleum and chemicalshas been adopted extensively in agriculture over the past years.Changes in these inputs, therefore, triggers changes in supply, and,by extension, the prices of the commodities that use these inputs(2009).

Thispaper discusses the relationship between exchange rates and oilprices in 10 net oil exporting and importing countries. Thequantitative research methodology will be used to bring therelationship between oil prices and the exchange rates of net oilimporting and exporting countries to bear. Morespecifically, the study will analyze the long run relation, determineshort-term dynamic adjustment to short term deviation and impulseresponse, and make forecast as per the equations developed.The study will begin by investigating the variables being studied byusing the Vector Error Correction Model approach, stationarity test,stability test, co-integration test, and Granger causality test.These tests will be used to determine whether a relationship existsbetween oil prices and exchange rates in net oil importing andexporting countries.

Afterthe preliminary investigation, co-integration between oil prices andexchange rates will be determined. If the relationship(co-integration) will be revealed, the existence of a long-termrelationship between the two variables will be studied. Thus, theVector Error Correction Model will be applied to determine theshort-term properties of the co-integrated series. The ImpulseResponse Function (IRF) will also be used. The IRF explains theresponse to shock amongst variables to reveal how random shock in onevariable affects another, both in the short and long run. In the end,the IRF will make forecasting possible, revealing causality orinteractive relationship between oil price and exchange rate.


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TheUS dollar is the primary medium of exchange when it comes to sellingand trading oil internationally (U.S. Energy InformationAdministration, 2015: 25). Thus, if the value of the dollardepreciates, the price of oil, and, by extension, demand, goes up andvice-versa. The first round of prices hikes, where oil pricesescalated to $10 per barrel, was experienced in late 1973(VERLEGER,2008: 46).The depreciating dollar and inflation was blamed for thebefore-mentioned phenomenon. The second major round of oil priceincreases (1978) was again attributed to the weakening value of thedollar, by oil exporting countries. Eight years later (1986), thevalue of the dollar appreciated, and, consequently, the price of oildeclined. In recent times, the dollar exchange rate and the prices ofoil have been connected (VERLEGER,2008).This paper discusses the relationship between exchange rates and oilprices in net oil exporting and importing countries.

1.2Oil Shocks: A Brief Historical Perspective

Inthe period between 1940s and 1970s, oil prices were significantlystable: oil price increases were gradual (Sill 2007). However, theperiod between 1970s and 1980s experienced a dramatic oil priceincrease. The sequence of steps leading to the dramatic increases inoil prices can be linked to the establishment of OPEC and irregularoil supply from the Middle East oil producing states. The 1973(October) Yom Kippur War led OPEC to realising the influence it hadover controlling the price of oil. After the European countries andthe U.S. supported Israel in the war, the OPEC placed an embargo onthe supply of oil to western countries. This move led to thereduction of oil production by 5 million barrels per day. As aconsequence, the cut-back resulted in a 400% increase in oil priceswithin a six month period (2007).

Nevertheless,the period between 1974 and 1978 experienced a relatively stable oilprice era (Sill 2007): oil prices ranged between $12 and $14 perbarrel. The 1979 and 1980 Iraq-Iranian war precipitated the nextround of oil price shocks. A significant decline in world oilproduction was realised: world production declined by 10%, leading tothe increase in the price of oil from $14 to $35. The vicissitudes inoil prices prompted OPEC countries to find a solution to the unstableoil prices. OPEC countries established production quotas however,the global recession, conservation efforts, and cheating onproduction by member countries led to a significant decline in oilprices by 1986: oil prices dropped to below $10 per barrel (2007).

Later,between 1990 and 1991, the Gulf War impacted the supply and prices ofoil (Izzard, 2010). In spite of the relatively low prices in 1990s,the OPEC member states made no effort to raise oil prices, keepingoil prices low for an extended period. However, after the Asianfinancial crisis in 1998, crude oil prices fell to $10 per barrel.This occurrence impelled OPEC to institute a chain of productioncuts, which began in late 1999. Consequently, OPEC regained controlover the oil market, leading to an increase in oil prices (2010).

Asa consequence of extensive swings in oil prices and the exchangerate, after Breton Woods’ breakdown, the link between oil pricesand exchange rates has evoked significant interest from researchers.

1.3Background of the Study

Asmuch as the link between crude oil prices and the dollar seemsexplicitly defined, a convincing theory explaining the coincidentmovement between crude oil prices and the dollar has never beenadvanced (VERLEGER,2008).The reason for this can be attributed to the complexity of the globaloil market: a myriad of factors affect fluctuations in oil prices(U.S. Energy Information Administration, 2015).

1.4Other Factors that Affect Crude Oil Prices

Althoughthe link between oil prices and exchange rates has been clearlyidentified, some factors also influence overall oil prices. Gainingan in-depth understanding of these factors helps the readerunderstand why economists find advancing a theory that defines thecoincident movement between the US dollar and oil prices somewhatperplexing.

  1. The Organisation of Petroleum Exporting Countries (OPEC)

TheOPEC is a consortium of 13 member countries. This organisation isaccountable for 40% of the globe’s oil production. It is the singlelargest body in the world that controls and implements policiesgoverning oil supplies. As a consequence, it can increase or decreasedemand by regulating oil production within member countries. Forexample, the increases in oil price between the years 2007 and 2008can be attributed to the reductions in OPEC oil production policiesin 2006 (U.S. Energy Information Administration, 2015).

  1. Supply and Demand

Globaloil inventories have provisions for balancing supply and demand.Thus, when oil production exceeds demand, the excess can be storedfor use in a later date, and when consumption super cedes demand, theinventories can be exploited to meet the increase in demand. Non-OPECmember countries are accountable for 60% of global oil production.While they (non-OPEC member countries) are 50% larger than OPECmember countries, they cannot control oil prices: they are subject tochanges in fluctuations due to insufficient oil reserves (U.S. EnergyInformation Administration, 2015).

Inaddition to the above, the amount of oil discovered, its geologicallocation, and the cost of extracting the oil are all subject tophysical factors. Since oil is a natural resource that isnon-renewable, physical factors come into play when it comes todetermining the cost of supplying oil from a specific reserve.Additionally, investment is indispensable when it comes to seekingand developing new oil reservoirs (U.S. Energy InformationAdministration, 2015).

  1. Restrictive regulations

Sincegovernment facilities and institutions control the workings of theglobal oil market, it is heavily politicised, and, as a result, itsfunctioning widely differs from that of the competitive market. Thus,factors such as taxes and energy prices in oil rich countries alsoaffect the price of oil in the end. If, for instance, a governmentdecides to shut down oil exploration in areas with proven oilreserves, for example, the Gulf of Mexico, commodity market considersuch an action as a “loss” in the supply of crude oil this leadsto an increase in gas prices (U.S. Energy Information Administration,2015).

  1. Political unrest

Ifan oil rich country experiences political instability, oil suppliersreact by raising their bid on the prices of oil thus, the highestbidder takes over the oil supply business in that country. Thebefore-mentioned causes price increases in oil due to the perceptionthat there is a decrease in oil supply, even though the cost of oilproduction may remain constant (U.S. Energy InformationAdministration, 2015).

  1. Financial Markets

Oilbrokers play the role of matching oil buyers to oil sellers. Oilbrokers also trade “futures” (contracts for the future deliveryof oil). Clients hedge on futures as a measure to guard theirprofitability against vicissitudes in the oil market. Oil producerspurchase futures to ensure oil is delivered at a particular price fora specified period of time. Finally, oil brokers purchase futures topromise their clients that oil will be delivered at a certain price(U.S. Energy Information Administration, 2015).

  1. Weather

Oil,like most products, is subject to demand changes due to weatherchanges. For instance, in winter, people use more oil for heatingpurposes while on summer, they use gasoline for driving purposes.Even though oil producers and suppliers know when to expect demandincreases, oil prices increase and level out with ach season of theyear. Extreme weather conditions can destroy infrastructure thus,inducing oil increases due to a reduction in supply (U.S. EnergyInformation Administration, 2015).

  1. Speculative Buying

Speculativebuying creates an environment where the prices of oil vary sincespeculators purchase and sell futures on an open market. Oilspeculation also induces investors to buy more oil since negativetension enters the market. A case in point was in 2008 wherespeculators bid up oil prices to levels that were thought to beunsustainable: $140 per barrel. In 2009, however, prices plummeted to$30 per barrel. The reason for the decline in prices was a sharpdecline in demand, which led to a decline in oil prices (U.S. EnergyInformation Administration, 2015).

  1. Non-OECD Demand

Developingcountries that are non-OECD have increased their oil consumptionsignificantly over the past years. Countries such as Saudi Arabia,India and China, for example, increased their oil consumptionto 40%in the period between 2000 and 2010 (U.S. Energy InformationAdministration, 2015). Thus, causing price increases due to highdemand.

1.3Factors that Affect the Foreign Exchange Rate of a Country

Zhou(1995), studied how various factors may come into play to explainvarying exchange rate movements: productivity shocks, oil prices,fiscal policies, among others. Afterwards, he showed how significantoil price changes were to real exchange rate movements. The followingdiscussion reveals some of the most critical factors that lead tofluctuations and variations in currency exchange rates, and pointsout the main reason behind each factor.

  1. Inflation Rates

Changesexperienced in market inflation extend to changes in currencyexchange rates. Countries that have lower inflation rates compared toother countries experience increases in the value of theircurrencies. By extension, the value of goods and services increase atrates that are generally lower, in countries with lower inflationrates. Thus, countries with low inflation rates experienceappreciation in the value of their countries while those with higherinflation rates, experience depreciation in the value of theircurrencies and usually proceeded by increased interest rates (Patel,Patel and Patel, 2014).

  1. Interest Rates

Thechanges realised in interest rates have a consequential bearing onthe dollar exchange rate and currency value. Inflation, foreignexchange rates and interest rates are all related. Thus, increasesin interest rates lead to appreciation in the currencies of countriessince higher interest rates lead to increased rates to lenders. As aresult, more foreign capital is accrued, in terms of foreign capital,causing a rise in the rate of exchange (Patel,Patel and Patel, 2014).

  1. Balance of Payments or the Current Account of a Country

Thecurrent account of a country is indicative of its foreign investmentearnings and balance of trade. The current account encompasses thetotal number of transactions, in addition to exports, debts, imports,etc. Depreciation is, therefore, realised when a deficit in thecurrent account develops as a result of spending more money onimports as opposed to exports. Balance of payment the localcurrency’s exchange rate (Patel,Patel and Patel, 2014).

  1. Government Debt

Governmentdebt is perceivable as public debt that the central government isresponsible for handling. Countries that have government debt areless likely to accrue foreign capital thus, leading to increases ininflation. Foreign investors usually prefer to vend their bonds inthe open market when the market predicts government debt within aparticular country. As a consequence, the value of the country’sexchange rate will also decline (Patel,Patel and Patel, 2014).

  1. Terms of Trade

Termsof trade can be viewed as a country’s export and import pricesratio. The terms of trade of a country go up when that country’sexport prices go up at a rate that super cedes the import of goods orimport prices. Higher revenues are realised as a result thus,leading to increased demand for that country’s currency, and, byextension, an increase in the value of that country’s currency(Patel,Patel and Patel, 2014).

  1. Political performance and Stability

Thestate of a country’s economic performance and political state isindicative of its currency’s strength. Countries that suffer frompolitical turmoil are less attractive investors, which leads tosignificant decreases in that country’s exchange rate. On the otherhand, a country that depicts less risk of political turmoil is moreattractive to foreign investment thus, pulling investors away fromcountries that are more stable economically and politically. As aconsequence, the country’s exchange rate appreciates significantly(Patel,Patel and Patel, 2014).

  1. Recession

Recessionsaffect the interest rates of countries fail. This leads to decreasedchances when it comes to acquiring foreign capital. As a consequence,the country’s currency falters in comparison to other countries,leading to a decline in the exchange rate (Patel,Patel and Patel, 2014).

  1. Speculation

Whenthe currency of a country, due to market forces, is expected to goup, investors will seek more of that currency so as to turn a profitin the near future. As a result, since that country’s currency isin high demand, its value goes up, and, by extension, an increase inexchange rate (Patel,Patel and Patel, 2014).

1.4LinkingOil Prices to the U.S. Dollar Exchange Rate

Aspointed out earlier, the US dollar is the primary medium of exchangewhen it comes to selling and trading oil internationally (U.S. EnergyInformation Administration, 2015: 25). Thus, gaining an in-depthinsight on how the relationship between the dollar and oil pricesworks is critical in understanding how oil prices affect exchangerates in general. In this regard, two primary causes can beattributed to the dollar’s effect on oil prices: the effect of thedollar on oil’s global demand and the effect of the dollar on theprice setting behaviour of oil producers (Grisse, 2010). Since theprimary currency used in international markets, to price oil, is theUS Dollar, oil becomes less expensive when the dollar depreciates.Reason being, the local currency in non-Dollar countries becomesstronger. As a result, demand increases, leading to an increase inoil prices (2010).

Bearingin mind the fact that oil is priced in dollars, the export revenue ofoil-producing countries is predominantly the US Dollar. However, USshipments account for a very small fraction of imports for oilproducers (Grisse, 2010). In addition, the majority of oil producingcountries compares their countries’ exchange rates to the Dollar.Thus, a depreciation of the dollar sparks a downward trend in thepurchasing muscle of oil revenues: what non-Dollar denominations(goods and services) can purchase (2010). Oil producers, therefore,opt to counterbalance the negative effects of the depreciating dollarby increasing oil prices. The before-mentioned means oil producers,to a greater extent, have the power to increase or decrease oilprices. For example, OPEC can increase the price of oil by limitingthe amount of oil that is supplied to the market (2010).

Furthermore,one can also consider the reverse effect that oil prices have onexchange rates (Grisse, 2010). Fluctuations in oil prices may affectthe dollar because of some factors. First is the impact thatincreases in oil prices have on the global outlook and the US dollar,and secondly, the impact that elevated oil prices have on trade flowsand the allocation of capital (2010). Specifically, the dollar couldincrease in value if markets speculate the US will suffer less fromincreases in oil prices compared to other economies due to factorssuch as the consumption of less energy (2010).

Inessence, increases in oil prices mean oil producers make more money(revenue) and oil-importers spend more – they save less (Grisse,2010). Perceived from the viewpoint that oil revenues are utilisedwhen it comes to the purchase of goods and services, in a manner thatis disproportionate from the US, the recycling of petro productscould imply the strengthening of the dollar (2010). Since the currentliterature points to the fact that oil exporters purchase goodsdirectly from the US, it is difficult to speculate where oilproducers invest their revenue. However, a big percentage of theprofits of oil producing countries, in the recent oil boom, pointdirectly or indirectly to the financing of the US current accountdeficit (2010).

1.5LinkingOil Prices to net Importing and Exporting Countries

Theoretically,studies have established that exchange rate appreciation in oilexporting countries is experienced when oil prices go up, andexchange rate depreciation when oil prices fall (Aziz, 2009). Thus,countries that have oil reserves could experience an increase in thevalue of their currencies in relation to the countries that have nooil when oil prices increase. On the flipside, oil producingcountries such as OPEC countries usually experience a negative effectin exchange rates when oil prices plummet. For example, in 1998 theprices of oil felt from 20$ to 13$ per barrel (due to the financialcrisis that arose in Asia), leading to a financial crisis in Russia,an oil exporting country. This led to the nominal value of the rubbleplummeting to over 70% in comparison to the US Dollar (from 6, 21RUB/US to 19,99 RUB/US) (Rautava, 2004). However, the country’seconomy recovered swiftly after the crisis since the weak ruble pavedway for improved price competitiveness of the domestic firms (2004).Thus, eventually, an export boom that was triggered by a decline inoil prices boosted Russia’s economy.

Conversely,in an oil importing country such as South Africa, oil pricesinfluence the country’s exchange rate through a two-way process:through supply and demand channels (Kin and Courage, 2014). On thesupply side, increases in oil prices results in increase inproduction costs, which by extension, leads to increases in the costsof production of non-tradable goods. The result of thebefore-mentioned is an appreciation of the exchange rate due to anincrease in the costs of non-tradable goods (2014). Perceived fromthe demand perspective, the exchange rate is indirectly influencedthrough its interaction with disposable income. Thus, an increase inoil prices decreases the power of consumers to spend. As a result,non-tradable products will be demanded less, leading to a decline inconsumer spending power. Ultimately, the decline in demand fornon-tradable items will lead to a fall in their prices and finally adecline in the value of the country’s currency (2014).

Thus,the consequences of oil price increases are felt differently in oilproducing and oil importing countries. Whereas oil price increases inoil producing countries can be perceived as good news, it isperceived as bad news in oil importing countries, the reverse in alsotrue (Al-Ezzee, 2011).

Theabove considered, this paper seeks to find the relationship betweenexchange rates and oil prices in net importing and exportingcountries.

1.6Statement of the Problem

Significantliterature points toward the effect of oil prices toward theperformance of economies (Aziz, 2009). For instance, oil price shockswere blamed for the 1970s and 1980s recessions. However, lessattention has been directed toward real exchange rates and oil prices(2009). Many researchers argue that oil price fluctuations have asignificant bearing on economic activity (Al-Azzee, 2011). As much asthe link between crude oil prices and the dollar seems explicitlydefined, a convincing theory explaining the coincident movementbetween crude oil prices and exchange rates in net importing andexporting countries has never been advanced (VERLEGER,2008). Although some researchers have linked shifts in exchange rates tooil shocks, empirical data in this area is somewhat inadequate(Ghalayini, 2011). Comprehensive research into this area could revealsome insightful findings.

1.7Purpose of the Study

Theprimary purpose of this study is to investigate the relationshipbetween oil prices and exchange rates in net oil importing andexporting countries. This paper is organised into five sections:Introduction, Literature Review, Methodology, Results, andConclusion. Throughout these sections, a close analysis of theeffects of real oil prices on the real exchange rate will be done.Since the dollar is the primary medium of exchange in the market, therelationship between oil prices and the rate of exchange of thedollar will also be examined. The relationship between oil prices andthe exchange rates of net oil importing and exporting countries,using the Vector Error Correction Model, will also be done. Moststudies concentrate on the effects of oil prices on net oil importingcountries, this study goes much further by seeking the answer to theimpact of oil prices on both oil importing and exporting countries.In particular, the following questions will be addressed:

  • How has history depicted the relationship between oil prices and exchange rates?

  • What is the relationship between the dollar and oil prices

  • What is the relationship between exchange rates and oil prices in net importing and exporting countries?

  • What future trends can be anticipated after studying the relationship between oil prices and the exchange rate?

1.8Significance of the Study

Anumber of reasons make this study critical. First, the gap thatexists between the relationships between oil and exchange rates issignificant – in terms of empirical data. Many researchers havebeen able to point out instances where oil price shocks triggeredfinancial crises, while others have pointed out the impact oil priceincreases have had on the performance of the currencies of countries.However, not many researchers have been able to provide a clear linkbetween oil prices and exchange rates. This study seeks to developinsightful findings around the before-mentioned: oil prices andexchange rates. In addition, the dollar exchange influences theperformance of oil prices, and vice-versa, however, the reason behindthis phenomenon is somewhat unclear (U.S. Energy InformationAdministration, 2015). Finding the answers to such questions wouldoffer insightful findings into the gaps surrounding the gaps in theacademic field.

Sinceoil prices and currency exchange rates have such a great bearing oneach other, this study has been conducted to provide further insightinto this field. The findings of this study advanced the existingbody of knowledge by testing the theoretical knowledge advanced bythe various researchers and analysts to develop a comprehensive bodyof knowledge encompassing the link between oil price changes and theexchange rate.

Azziz(2009), for example, pointed out that oil price shocks were blamedfor the 1970s and 1980s recessions. Meaning, increases or decreasesin oil prices has a profound effect on the performance of economies.However, economists such as Ghalayini (2011) state that in spite ofthe wide literature linking oil price increases or decreases to theperformance of exchange rates, little empirical literature exists toshow the explicit relationship between the performance of oil and therate of currency exchange. This study goes back in history, revealsthe links between oil price changes and the exchange rates, and thenseeks to find the clear link between the exchange rate and oil pricechanges. The study employs the quantitative research methodology tobring the relationship between oil prices and the exchange rates ofnet oil importing and exporting countries. Morespecifically, the study will analyze the long run relation, determineshort-term dynamic adjustment to short term deviation and impulseresponse, and make forecast as per the equations developed.


Thisstudy researchestherelationship between oil price changes and exchange rates in oilimporting and exporting countries. Previous research and studies in amyriad of fields have been used to come up with a comprehensive bodyof information covering this relationship. The researcher studies thebehaviour of exchange rates when oil prices, in netimportingcountries such as South Africa, China and India,increases.The study also compares how the exchange rates of net exportingcountries like Russia, Saudi Arabia, and Mexicoisaffected by increases and decreases in oil prices. The Vector ErrorCorrection Model approach of stationarity test stability test,co-integration test, and Granger causality test will be used toreveal the real impact of oil prices on exchange rates in oilimporting and exporting countries. In addition, Time Series Analysiswill be used to analyse the data that will be collected.


2.0Literature Review

Exchangerates are critical factors when it comes to determining the level oftrade of a country, which is crucial to most free market economiesworldwide (Asari et al., 2011). Therefore, most people and investorswatch exchange rates with close interest to understand how well orpoorly a particular economy is doing. Governments also manipulatethese economic measures – by placing regulatory limits on thetransfers of exchange rates – in an attempt to keep in check localcurrency fluctuations (2011). However, such government actions can attimes be dangerous or even pointless when investors decide to attacka particular currency. In most cases, volatile exchange rates hindereconomic growth, prevent capital outflows, and even hurt the economysometimes (2011).

Theabove considered, many researchers and economists have accepted thatoil price shocks contributed to most of the economic recessions thathit the world (Aziz, 2009). For example, in 1973-74, unexpected oilprice hikes precipitated the appreciation of the US dollar. However,in 1979, the dollar experienced depreciation after oil prices rose.In the 1980s, the same pattern was, again, realised. More recentlyoil prices remained relatively low until 2007 when they hiked, andthe value of the dollar depreciated once again (2009). The questionhere remains: is there any rational explanation for the behaviour inthe foreign exchange market or is it simply reaction to what othertraders think? A simple answer to this question may be hard todevelop however, one can develop insight into this issue throughanalytically examining the link between oil price changes andexchange rates.

Sinceprice indices that comprise various commodities with differentweights are used to compute real exchange rates, real exchange ratescan be perceived as relative prices (Aziz, 2009). In addition,because the extent to which countries consider oil an output that isincluded in the commodity price index, changes in non-stationary oilprices are reflected in non-stationary real exchange rate changes(2009). A good number of researchers who studied the contribution ofoil price changes to the non- stationary performance of real exchangerates through the post-Bretton Woods eraacquiesced over the findingsobtained. Evidence gathered over this period established the factthat oil price changes and real exchange rates are co-integrated. Inaddition, the findings also reveal that oil price changes may beattributed to the non-stationary activities of the US Dollar realexchange rate and persistent shocks over the post-Bretton Woods era(2009).

Intheory, oil exporting countries experience exchange rate appreciation– a decrease in the value of exchange rates – when oil pricesincrease and exchange rate depreciation – increase in the value ofthe local currency – when oil prices decrease. Studies haveestablished a negative relationship between oil prices and exchangerates in countries that export oil. In other words, oil pricesincreases cause an appreciation of the local currency in oilexporting countries (Aziz 2009).

Benassy-Quereet al. (2007), in a study carried out between 1974 and 2004, onco-integration and causality between the real price of the dollar andthe real price of oil, discovered that if other factors remainedconstant, a 10% increase in the price of oil led to a 4.3%appreciation in the value of the dollar. Additionally, Amano and vanNorden (1998) established a link between the real US effectiveexchange rate and oil price shocks in the long run. The findings ofthese researchers indicate that oil price changes have triggeredpersistent shocks, over the past years, on the exchange rate.

Theabove considered, this paper uses a two-pronged approach. Instead ofstudying the effect of oil price changes on import oil countries orexport oil producing countries in solitude, it combines bothapproaches to offer in-depth insight on the effect of oil prices onboth types of economies. Secondly, the oil price change and exchangerate link will be analysed using various co-integration methods,which enhance the capacity of tests.

Asample of 10 countries, comprising 5 net oil producing countries and5 net oil importing countries using monthly panel data will be used.Net oil exporters include Russia, Venezuela, Norway, Saudi Arabia,and Mexico. Net oil importers include India, South Africa, China,Brazil, and Japan.

2.2TheImpact of Oil Price Changes on the Exchange Rates of Net OilImporting Countries

Oilimports represent a significant part of trade balance in energydependent countries (Kim and Courage, 2014). Various authors havelinked oil prices to shifts in exchange rate: Aziz (2009), Amano andvan Norden (1998), Basher et al. (2011), among others. Dawson (2004)asserts that changes in oil prices have consequential effects on therelative values of the currencies of small open economies. Literatureconcerning the effects of oil prices on exchange rates usuallyconcentrates focus on oil exporting countries. The followingdiscussion takes a different approach: it discusses the impact oilprices have on the exchange rate of oil importing countries.

2.2.1South Africa

SouthAfrica is a small open economy that is energy dependent and has afloating exchange rate. The Energy Information Authority (2013)asserts that the current consumption of oil in South Africa isapproximately over 20% of the total amount of energy used. SinceSouth Africa lacks commercial oil deposits, it is dependent on oilreserves from oil producing countries to fuel its energy needs (Kimand Courage, 2014). Statistics (EIA, 2013) reveal that South Africais highly dependent on oil imports, and out of the country’s totalimports, oil accounts for 6%. Additionally, South Africa also importsmore 90% of its crude oil thus, exposing the country to externalshocks that either disrupt routine business activities or lead toescalation of oil prices. In the end, the before-mentioned results indisrupted economic growth or development (Kim and Courage, 2014).Another cause of concern is that South Africa’s key sectors,transport and agriculture, are highly dependent on oil products as aresult, any shifts in oil prices can have a profound effect on SouthAfrica’s economy (2014).


Indiais ranked 7thin terms of land mass (3.29 million square kilometres), and second,in terms of population – more than 1.2 billion people(Hidhayathulla1 and Mahammad Rafee, 2014).India’s populationaccounts for 17.2% of the world’s population and has to produceapproximately 1.2 trillion worth of GDP to cater to the needs of thelarge population (2014). As a consequence, the country requires aminimum of 2.5 million barrels a day to produce the trillion dollarwork of output it needs. India’s oil needs represent 4.4% of theworld’s demand for oil (2014). The growth rate of oil demand isapproximately 6.8% (2014). Thus, the continued demand for oil exertsprofound pressure on the country’s inflation and growth levels.International oil prices are likely to have consequential effects onIndia’s domestic prices (2014).

InIndia’s case, however, oil shocks have not had a very profoundeffect on domestic prices (Hidhayathulla1 and Mahammad Rafee, 2014).Reason being, India had an administrated price mechanism that shieldsits from the negative impacts of oil shocks. The Indian governmenthas seized control over the administrated price mechanism in the oilsector and opted to link local oil prices to international oilprices. Nevertheless, oil prices remain an external factor to India’seconomy as a result, affecting the Indian currency (Rupee) since theUS Dollar is the medium of exchange in the International market(2014). Public sector oil companies have thus resorted to sharing theload of oil price increases in the form of inflation. The Indiangovernment supports public sector companies through the budget. Forinstance, the Indian government recently deregulated all petroleumitems apart from Kerosene and the LPG cylinder (2014).

SinceIndia is an oil importing country and energy the driver of economicgrowth, oil consumes a substantial portion of the country’s foreignexchange revenue (Hidhayathulla1 and Mahammad Rafee, 2014). India’soil import costs account for approximately 30% of the total imports.In the first five months of 2013, India’s import costs went up by9.5%. India is dependent on imports to meet 80% of her needs (2014).


Shiftsin the real exchange rate in China involve an intricate structuresince the country is seemingly moving toward higher economicintegration with the rest of the world (HUANGand GUO, 2007).In fact, in the period between 1995 and 2004, China consumedone-third of the entire world’s incremental oil demand. Inaddition, China’s net oil import is expected to grow three-foldover the next 20-year period (2007). The before-mentioned considered,large oil price shocks could play a significant role in causingshifts in the exchange rate.

However,China’s decision to depegg the renminbi (RMB) from the US Dollarhas made understanding the impact of oil price shocks on thecountry’s exchange rate somewhat perplexing (HUANGand GUO, 2007).China shifted to a currency that gave leeway to a system that allowedthe country’s currency to float within a significantly narrow bandalongside a mixed basket of monies from the country’s chief tradingpartners. For extended periods, analysts have perceived the RMB asbeing heavily regulated. The actual path of the bilateral exchangerate offers limited information in developing a systematic pattern orlink to other macroeconomic variables (2007).


Brazilis a net importer of oil: it is a dominant player in terms of oildemand (Adıguzelet al., 2013).The country is at positions seven, in the list of the world’s mostoil-demanding countries. Brazil consumes more than 5 barrels on adaily basis, and its share in the global oil demand is 3.1%. WorldEnergy Outlook (2007) Brazil has had a continued increase in oildemand. The country imports 80% of its oil, and uses 40% of itsexchange rate to pay for the imported oil. Thus, a slight increase inoil prices is expected to affect Brazil’s rate of exchangesignificantly. The move by Brazil shift its exchange rate from fixedto floating, and, subsequently, increase its demand for oil wasinformed by the need to examine the link between exchange rates andoil prices (Adıguzelet al., 2013).Delineating this link presents crucial information that helps preventexchange rate fluctuations that are caused by oil shocks.

Brazilis a member of the BRIC countries (Adıguzelet al., 2013).Her counterparts are Russia, China, and India. The BRIC have beencategorised as being the fastest emerging and growing economies inthe world today (2013). These countries account for more that 40% ofthe globe’s populace and command 17% of the total income of theworld. Economists speculate that these countries will be positionedamong the top 10 largest economies, by 2020. By 2050, it is expectedthat these countries will be the most important economies, followedby the US, which will be at position 5. Turkey is also expected tojoin the BRIC frontier due to her stable growth and potential foreconomic development over the last decade (2013).


Foran extended period, the Japanese economy has experienced a profoundeffect in exchange rate fluctuations and the prices of crude oil(Tokuo and Hayato 2015). Japan relies on oil imports from oilproducing countries thus, policy makers and Economists have beenplacing more emphasis on the impact of crude prices on the yen. Inparticular, since post war Japan has been heavily relying on crudeoil imports to drive her economy, which means an increase in oilreduces the strength of the yen significantly. A case in point is theappreciation of the yen after the Plaza Accord of September 1985.This event resulted in the subsequent recession of the yen in 1986.The recession is believed to have occurred due to the internationalpolicy coordination that was intended to correct the overvaluation ofthe US dollarin the 1980s: it was believed to be Reaganomics-induced(2015). During the same period, the yen appreciated after the pricesof crude oil dropped, subsequent to the early 1980s second oil priceshock.

2.2The Impact of Oil Price Changes on the Exchange Rates of Net OilExporting Countries


Russiais highly dependent on oil exports: it is the second largest exporterof oil in the world,afterSaudi Arabia (Gedek 2013).Thecountry mainly exports natural gas and oil. In 2009, oil accountedfor 50% of Russia’s exports, and contributed to 30% of all ForeignDirect Investments. Thus, the country’s economy is highlysusceptive of changes in oil prices. In 1998, for example, thecountry suffered a major crisis after the Russian ruble depreciateddue to a substantial drop in oil prices. However, the rubbleappreciated by over 80% between 1999 and 2008 after oil pricesincreased. Russia’s economy flourished during this period becauseof the boom in price-exports, which eased liquidity constraints inthe economy.


Norwayis one of the giants in the oil exporting industry (Akram, 2004).However, unlike most countries, The Norwegian exchange rate reveals anegative relationship with oil prices. Studies conducted on thebehaviour of the Norwegian currency (krone) reveal that it remainsrelatively strong despite the depreciation of oil prices: $14andbelow. For instance, the Norwegian krone experienced an appreciationbetween 1996 and 1997 (when oil prices decreased), and thendepreciated in the period between 1998 and 1999 (when oil pricessurged) (2004). Also, the devaluation of the krone in 1986isattributable to the decline in oil prices in the period between 1986and 1987


Inthe period between December 2002 and February 2003, Venezuelaexperienced an oil strike that crippled its economy significantly.The country lost over 29% of her GDP. However, between the 2003 and2008 period, Venezuela’s economy grew rapidly: the country’s GDPalmost doubled. However, in the first quarter of the year 2009, thecountry experienced another recession (Weisbrot and Johnston, 2012).

Studies(Rodrik,2009) reveal that there is a close connection between an increase inthe value of a country’s exchange rate and economic growth. Thus,deducing from the above discussion, one can conclude that oil pricescontributed the strengthening and depreciation of Venezuela’sexchangerate. Between December 2002 and February 2003, Venezuela experiencedan energy crisis after the oil strike, which led to the collapse ofher economy. However, between 2003 and 2008, research reveals thatoil prices had surged thus, leading to a significant improvement inVenezuela’s economy, and, by extension, the strengthening of thecountry’s exchange rate. In the fourth quarter of 2008, oil pricesdeclined, leading to another recession in 2009 (Weisbrotand Johnston, 2012).


Mexicois a net oil exporter meaning higher oil prices are usuallypreferred over lower prices (Lajous 2014). Lower prices, however,also offer opportunities that Mexico can seize, for instance,eliminating price subsidies. Compared to most oil exportingeconomies, Mexico is more diversified: oil contributed around 6% ofthe country’s GDP. In 2014, oil export revenues accounted for 12%of the total exports (2014).

Oilplays a critical role in catering for Mexico’s public finance,considering Mexico’s low tax burden (Lajous 2014). Oil-relatedrevenues account for about 33% of the Mexican government’sreceipts, which means lower revenues result in reduced foreignreserve accumulation. The USD/MXN, therefore, have a negativecorrelation. Oil prices, in most cases, result in an increase in thevalue of the USD.MXN, meaning the peso depreciates against the dollar(Cassilas and Paredes 2014).


Oilrepresented 21.4% of Canada’s exports in the period between 1972and 2008 (Ferraro, Rogoff, and Rossi 2011). Canada’s economy is asmall open economy that utilises a market-based floating exchangerate, with a relatively small size in the world market. For thisreason, changes in the prices of crude oil can both be observed andreveal terms-of-trade shock within the Canadian economy (2011).

Studies(Aguilar 2013) have revealed the relationship between an increase indemand of exports in a country and an increase in the value of thatcountry’s currency. The Canadian dollar is not an exception to thisrule. The value of the Canadian dollar goes up when the global demandfor the dollar increases (2013). If net oil importers, for instanceOPEC countries, restrict oil supply, Canada’s oil will alsoexperience an increase in demand, and, by extension, escalate thevalue of the Canadian dollar (2013).


Aspointed out earlier, the dollar is typically the preferred currencyin trading oil in the international market (Zhang 2013). As aconsequence, studies (2013) have revealed the existence of arelationship between the dollar crude oil prices. Since 2002,increases in the prices of oil have sparked depreciation in the valueof the dollar (2013). The economies of energy dependent countries (toa large extent) depend on oil, which represents a significant portionof their trade balance (Dawson 2004). Small open economies, withfloating exchange rates, experience a significant impact on the valueof their currencies when oil prices change. The before-mentionedrelationship has had a profound impact on both oil importing andexporting countries. When the prices of oil increase, wealth isusually transferred from oil importing to oil exporting countries(Zhang 2013). The reason for this is when oil prices increase theincome of oil exporting countries also increases. In essence, oilprice trends over the past years have precipitated fluctuations inexchange rate movements in both oil importing and oil exportingeconomies (2013). This relationship has not been examinedextensively, thus, the following section develops tools that will beused to investigate the link between oil prices and exchange rates inan in-depth manner.



3.1.The Method of Data Collection and Data Source

Thisstudy begins by investigating the variables being studied by usingthe Vector Error Correction Model approach, stationarity test,stability test, co-integration test, and Granger causality test.These tests will be used to determine whether a relationship existsbetween oil prices and exchange rates in net oil importing andexporting countries. After the preliminary investigation,co-integration between oil prices and exchange rates will bedetermined. If the relationship (co-integration) will be revealed,the existence of a long-term relationship between the two variableswill be studied. Thus, the Vector Error Correction Model will beapplied to determine the short-term properties of the co-integratedseries. The data used in the analysis will be gathered from peerreviewed sources and studies on the impact of oil shocks on exchangerates. The Impulse Response Function (IRF) will also be used. The IRFexplains the response to shock amongst variables to reveal how randomshock in one variable affects another, both in the short and longrun. In the end, the IRF will make forecasting possible, revealingcausality or interactive relationship between oil price and exchangerate, in addition to using oil prices to forecast the exchange rateor both ways based on the VECM model.

3.2Theoretical Framework

Exchangerates have a significant impact on the value of import and export ofgoods and services (Harry, Nalley, and Hudson 2009). The prices ofgoods and services traded in particular countries, therefore, areimpacted significantly by the exchange rate. Similarly, energyimpacts the production of commodities in critical ways. Inagriculture for example, the use of petroleum products has increasedsignificantly over the past years thus, the price of petroleum isexpected to have an impact on the price and supply of agriculturalproducts (2009).

Studies(Harry, Nalley, and Hudson 2009) have also linked the price ofpetroleum to that of commodity prices. A close relationship betweenincreasing crude oil prices and a widening U.S. current accountdeficit has been established over the past years. The result of awidening current account is a depreciating currency, making exportsmore attractive compared to imports. Since 2004, a significantincrease in crude oil prices has been realised and the value of thedollar decreased in comparison to other countries’ currencies (bothlow and high income).

Nevertheless,literature on the impact of oil price shocks on exchange rates isrelatively slim (Harry, Nalley, and Hudson 2009). Changes in theprices of these variables are very significant when it comes todeveloping risk management strategies and long-term policy decisions.Using the existing literature, on the relationship between oil pricesand exchange rates, one can develop a linkage between oil prices andexchange rates, as illustrated in Figure 1. Assuming that a productsuch as oil, a dollar-denominated product, is affected by dollarexchange rates is reasonable. Direct empirical literature revealingthis relationship is, however, very scant.

Figure1: Linkages between Oil, Exchange Rates and Commodity Prices





Input Prices

Commodity Prices


Thisstudy will collect data from 10 countries: five net importers andfive net exporters of oil. Past studies and trends on the effect ofoil on the exchange rate will be used to establish whether arelationship exists between these two variables. After getting thesestatistics, the researcher will subject them to a number of tests toestablish whether a real connection exists between oil prices andexchange rates. The tests used are the VECM, Granger causality test,the stationarity test, the co-integrationtest, and the stability test. In particular, the following issueswill be addressed:

  • How has history depicted the relationship between oil prices and exchange rates?

  • What is the relationship between the dollar and oil prices

  • What is the relationship between exchange rates and oil prices in net importing and exporting countries?

  • What future trends can be anticipated after studying the relationship between oil prices and the exchange rate?


3.4.1Stationary testAstationary test is identified as a stochastic process in which jointprobability distributions do not change when exposed to shifts intime(Asari,2011).With regards to this, it is realized that parameters such as varianceand mean, if present tend not to change with time and also do notfollow a particular trend. All in all there are various advantages oftesting non-stationarity. One of them being that the stationarity ofa particular series influences the series behaviour and properties.The other main reason of testing for stationarity is to identifymatters related to spurious regression. This basically means that iftwo variables tend to trend over time, the existence of regression ofone of them could have the possibility of having a high R^2 even ifthe two are not related (2011). Thereare usually two specific models used to test for non-stationarity,that is, the deterministic trend process and the random walk modelwith drift:Yt=μ+yt-1 +ut(random walk model with drift)Yt= α + βt+ ut (deterministic trend process)assumingthat utisiid in the above cases.

3.4.2Vector Error Correction Models

TheVector Autoregressive Model is a comprehensive framework used toreveal the dynamic relationship that exists among stationaryvariables(Hauser2010).Thus, the first step in time series analysis is to establish whetherdata levels are stationary. If time series are non-stationary, theVAR framework is usually modified to allow for a more consistentapproximation of relationship among series. The Vector ErrorCorrection Model is a modified approach of the VAR for variables thatare stationary in their differences: I (1). The VECM also takes intoaccount co-integrating relationships among variables (2010).

Thefollowing vector error correction model (VECM) equations have beendeveloped in this regard.

ΔlnEXPt= ө2 + Σb Φ2(i)ΔlnEXCt-i + Σb Ω2(i)ΔlnIMPt-i + Σbg2(i)ΔlnEXPt-i + ψ2Et-1 + e2t (1)

ΔlnIMPt= ө3 + Σc Φ3(i)ΔlnEXCt-i + Σc Ω3(i)ΔlnEXPt-i + Σcg3(i)ΔlnIMPt-i + ψ3Et-1 + e3t (2)

ΔlnCOPt= ө1 + Σa Φ1(i)ΔlnEXPt-i + Σa Ω1(i)ΔlnIMPt-i + Σag1(i)ΔlnCOPt-i + ψ1Et-1 + e1t (3)


Δ= First-differenceoperator

E= Errorcorrection term

ө,Φ, Ω, g, ψ = Parametersto be estimated

a,b, c = Laglengths

Et-1= Speed of adjustments of ΔlnEXCt, ΔlnEXPt, and ΔlnIMPt towardslong-run equilibrium levels. The error correction terms can thus bedeemed as providing long run causal relationships in the equations

3.4.3Co-integration testTheco-integration test identifies the equilibrium relationship betweentime series that tend to be individually not in equilibrium(Asari,2011).It comes in handy when allowing a researcher to incorporate both thelong-term expectations and the short-term dynamics. When testing forco-integration, once the variables have been classified as integratedin the order I(0) , I(1), I(2), it becomes possible to set up aspecific model that allows the researcher to bring forth thestationary relationship between variables, and also where it ispossible to acquire standard influence. With regards to this, thenecessary criteria or method of stationarity among non-stationaryvariables is what is referred to as co-integration. This, therefore,means that co-integration is a necessary tool in checking whether achosen modelling criteria brings forth meaningful relationships(2011). 3.4.4The Granger Causality testThegranger causality test is one of the tests used in statisticalhypothesis(Asari,2011).The test is used to determine whether a particular time series isuseful in forecasting another time series. The granger causality testusually stipulates that if a particular signal y1 “granger causes’signal y2, in this case the past value of the unit y1 should be ableto help in predicting signal y2, this is with regards with the pastvalues of y2 alone (2011). 3.4.5.Impulse Response Function (IRF)ImpulseResponse Function is a tool used to track the impact that anyvariable has on other variables in a system (Lin 2006). The IRFreveals the empirical causal analysis and policy effective analysisof variables. Theabove can be perceived as follows, where Ytisa k-dimensional vector series that can be generated as follows:Yt= A1Yt−1+· · · + ApYt−p+UtI= (I − A1B− A2B− · · · − ApBp)Φ(B)assumingcov(Ut) = Σ, Φi is the MA coefficients that are used to measureimpulse response. Φjk,i is representative of the response thevariable jhas on a unit impulse in the variable k,that occurredithperiodago. IRF can be used to evaluate how effective a policy change is,for example, the impact of oil prices on the exchange rate of acountry. 3.5Details on the Sources of DataThedata used in the research has been derived from ten differentcountries: 5 net-oil importing countries and 5 net-oil exportingcountries exporters: Russian Federation, Norway, Venezuela, Mexico,Canada importers: China, Japan, South Africa, India and Brazil.Table2 represents the data with variables of net-oil importing, net-oilexporting countries and crude oil prices. The data was taken from theEconomic Research, Federal Reserve Bank of St Louis(,which was uploaded 2016-02-01at 3:41 PM CST&nbspfor all exchange rates and for crude oil priceswas uploaded 2016-01-13 at 1:41 PM CST. All data is not seasonallyadjusted&nbspand it is with monthly frequency. For RussianFederation the data for 2015 has been taken from X-Rates page(

Variables Source Units Data Range
Net-oil Importers
South Africa Board of Governors of the Federal Reserve System (US)

South African Rand to One U.S. Dollar

1971-01-01 to 2016-01-01
India Board of Governors of the Federal Reserve System (US)

Indian Rupees to One U.S. Dollar

1973-01-01 to 2016-01-01

China Board of Governors of the Federal Reserve System (US)

Chinese Yuan to One U.S. Dollar

1981-01-01 to 2016-01-01

Brazil Board of Governors of the Federal Reserve System (US)

Brazilian Reals to One U.S. Dollar

1995-01-01 to 2016-01-01

Japan Board of Governors of the Federal Reserve System (US)

Japanese Yen to One U.S. Dollar

1971-01-01 to 2016-01-01

Net-oil exporters

a) Organization for Economic Co-operation and Development

b) X-Rates

a) 1992-06-01 to 2014-12-01

b)2015-01-01 to 2016-01-01

Norway Board of Governors of the Federal Reserve System (US)

Norwegian Kroner to One U.S. Dollar

1971-01-01 to 2016-01-01

Venezuela Board of Governors of the Federal Reserve System (US)

Venezuelan Bolivares to One U.S. Dollar

1995-01-02 to 2016-01-01

Mexico Board of Governors of the Federal Reserve System (US)

Mexican New Pesos to One U.S. Dollar

1993-11-01 to 2016-01-01

Canada Board of Governors of the Federal Reserve System (US)

Canadian Dollars to One U.S. Dollar

1971-01-01 to 2016-01-01

Crude oil spot prices (West Texas Intermediate (WTI) – Cushing, Oklahoma) US. Energy Information Administration Dollars per Barrel 1986-01-01 to 2015-12-01

5.0ProcedureThedata used in this particular research was archival data, whichdisplayed the trends in theeffect of exchange rates since 1971 to2015. For purposes of uniformity in comparison and statisticalanalysis, the research period will be from 1995-01-01 to 2015-12-01,so it means that there were considered 20 years in data analysis withmonthly frequency. Considering the fact that the data presented inthe archival data represents the figures for each month for aspecific year. The average units for all the 12 months was used indrawing the graph that represented the trend of oil prices withregard to the exchange rates for the 10 countries that wereconsidered for the study both the exporters and importers. Exporters:Russia, Norway, Venezuela, Mexico, Canada importers: China, Japan,South Africa, India and Brazil.6.0Limitation of methodologyThespecific methodology used in the analysis of data for this researchis the vector error correction model, which applies the vectorautoregressive model to integrate multivariate time series. Theprimary problem of the vector auto regression model in theintegration of time series is the introduction of spuriousregression. In this case the t-statistics tend to be highlysignificant and the R^2 tends to be higher despite the fact thatthere is no relation between the two variables. 7.0Program used for AnalysisSincethis study is primarily quantitative, R-studio will be used toanalyse data. R-studio will bring to bear the reliability of theresearch instruments in displaying the relationship between thedependant and independent variables. R-Studio is ideal because ithelps the researcher to use R in a manner that is more user-friendly.It also helps one to compute more easily and display the relationshipbetween variables in a manner that is easy to understand andapplicable in different situations. Chapter 44.0Results 1.1Introduction

Themonthly data covering a 20 year period, 1995 to 2014, was obtainedfrom both the Board of Governors of the Federal Reserve System (US)and the Organizationfor Economic Co-operation and Development (OECD)database. Theaim of the study was to analyze the relationship between oil pricesand exchange rates in net oil exporting and net oil importingcountries. More specifically, the study sought to analyze the longrun relation, determine short-term dynamic adjustment to short termdeviation and impulse response, and make forecast as per theequations developed.

1.2 Longrun relation

First,the study checked how exchange rates net oil exporting and net oilimporting countries react to a disturbance in the price of oil. Tothis end, the study analyzed the long run relation with help of VECMlong run co-integration as in Aziz (2009) and Harri et al. (2009). Tohelp in this, time-series Vector Error Correction Model approach wasused in checking for stationarity, co-integration, stability test andGranger causality. To get apriory idea about the variables analuzed in the present study, figure1.1 below was run. The blue line represents net importing countrieswhile the red one indicates crude oil prices and black is for netexporting countries.

Figure1.1 Exporters,Importers and Crude oil prices

Fromthe figure, it can be established that exchange rates in netexporting countries move relatively close across the years ascompared to exchange rates in net exporting countries.


Thestudy firstconducted unit root tests to see if the series are stationary.Whereas there exists several unit root tests to check forstationarity, the study employed the Augmented Dickey-Fuller (ADF)test to examine the stationarity of the series. The critical valuesare benched marked against Dickey et al. (1981) values.

Table1.1:Augmented Dickey-Fuller (ADF) test results



No constant

Constant only

Trend and Constant






First Difference









First Difference




Crude oil prices





First Difference




Allvariables are in log forms. The optimal lag lengths are determined byShazam default, according to AIC and SC, and are given inparenthesis.

Thestudy proceeded with the hypothesis that there existsnon-stationarity in the series, that is, there exists unit rootsacross the equations. Results are presented at 1%, 5% and 10%critical values. From the findings in the table, it was establishedthat at level form, the null hypotheses, that is, variables arenon-stationary, cannot be rejected, as test statistics are greaterthan the provided critical values for all equations, that is, with noconstant or trend, with constant only and with both trend andconstant. Unit roots can thus be said to exist in all the models intheir level forms. When converted to their first differences however,all variables become stationary and can be considered as integratedof order one.


Cointegrationtest was performed to see possible long run relationship among thevariables. Following the unit root test, as the series were found tobe cointegrated, a Vector Error Correction Model (VECM) wasconstructed with a view to further check on the behavior of theseries. To test for cointegration, the study adopted theJohansen-Juselius (1990) testing procedure. Two cointegration testingprocedures are provided for in the Johansen-Juselius test, to detectthe number of cointegrating vectors. They are called traceandmaximumeigenvalue teststatistics. Results for the tracetest statistics are as presented in table 1.2 below.

Table1.2: Johansen-Juseliuscointegration

Trace statistics





r &lt= 2





r &lt= 1





r = 0





Eigen statistics





r &lt= 2





r &lt= 1





r = 0





Intrace statistics the null hypothesis, which states that there are atmost rnumberof cointegrating vectors was adopted. To this end, the equation,λtrace= T Σj=r+1,n ln(1-λj),was adopted, where: T= Numberof observations λjs= Estimated values of the characteristic roots and by assuming thatthe variables are I(1).Findings as presented in table 1.2 above indicate that at 1%, 5% and10% critical level, the null hypothesis that there are at most 2, 1and 0 number of cointegrating vectors cannot be rejected both inTraceand Eigenstatistics.

1.2.3Stability test

Totest for model stability, the study employed Pearson`s Chi-squaredtestof independence, proceeding with the hypothesis that exchange ratesare independent of fluctuations in crude oil prices for both netexporting and net importing countries. Findings are as presented intable 1.3 below.

Table1.3 Model Stability Test




Crude oil prices





Fromthe results presented in table 1.3 above, taking the standard 0.05level of statistical significance, the study did not reject the nullhypothesis, having established a p-value of 0.2358. It follows thenthat exchange rates are independent of fluctuations in crude oilprices for both net exporting and net importing countries.

1.2.4Granger causality test

Todetermine the direction of influence among the study variables, thatis, exchangerates in net exporting and net importing countries and crude oilprices, the study performed a Granger causality test. Findings are aspresented in table 1.4 below. Four null hypotheses were set to thiseffect:

H01:Exchange rates in net exporting countries does not granger causeCrude oil prices

H1:Exchange rates in net exporting countries does granger cause Crudeoil prices

H02:Exchange rates in net importing countries does not granger causeCrude oil prices

H2:Exchange rates in net importing countries does granger cause Crudeoil prices

H03:Crude oil prices does not granger cause Exchange rates in netexporting countries

H3:Crude oil prices does granger cause Exchange rates in net exportingcountries

H04:Crude oil prices does not granger cause Exchange rates in netimporting countries

H4:Crude oil prices does granger cause Exchange rates in net importingcountries

Table1.4 Grangercausality test results

Null Hypothesis















Findingsestablished in table 1.4 above reveal P values greater than 5%. Inthis regard, the study does not reject any of the four proposed nullhypotheses. It follows then that exchange rates in both net exportingand importing countries do not granger cause crude oil prices. Crudeoil prices do not also granger cause exchange rates in both netexporting and importing countries. These findings further supportresults from the model stability test in which case the variableswere found to be independent of each other.

1.2.5Short-term dynamic adjustment to short term deviation

Thestudy sought to determine how the shocks will affect the oil priceand exchange rate in both the short and the long run with the help ofanumber of Vector Error Correction Equations which would also explainthe impulseresponse function amongst the variables to see how the random shockto one variable will affect another. Results are as presented intable 1.5 below. Thefollowing vector error correction model (VECM) equations weredeveloped in this regard.

ΔlnEXPt= ө2 + Σb Φ2(i)ΔlnEXCt-i + Σb Ω2(i)ΔlnIMPt-i + Σbg2(i)ΔlnEXPt-i + ψ2Et-1 + e2t (1)

ΔlnIMPt= ө3 + Σc Φ3(i)ΔlnEXCt-i + Σc Ω3(i)ΔlnEXPt-i + Σcg3(i)ΔlnIMPt-i + ψ3Et-1 + e3t (2)

ΔlnCOPt= ө1 + Σa Φ1(i)ΔlnEXPt-i + Σa Ω1(i)ΔlnIMPt-i + Σag1(i)ΔlnCOPt-i + ψ1Et-1 + e1t (3)


Δ= First-differenceoperator

E= Errorcorrection term

ө,Φ, Ω, g, ψ = Parametersto be estimated

a,b, c = Laglengths

Et-1= Speed of adjustments of ΔlnEXCt, ΔlnEXPt, and ΔlnIMPt towardslong-run equilibrium levels. The error correction terms can thus bedeemed as providing long run causal relationships in the equations

Inequations (1), (2) and (3), various types of Granger-causalityrelationships can be obtained as follows:

i)H0:Ω1=0 and H0:Φ1=0 forall (i) indicates short run or weak Granger causality relationship.

ii)H0:ψ1=0 indicatespresence of long run causality among the variables. If ψ1=0,thismeans that COP does not respond to the deviations from the long runequilibrium in the previous period.

iii)H0:Ω1=ψ1=0 andH0:Φ1=ψ1=0forall (i) gives strong Granger causality relationship among thevariables.

Table1.5: Resultsfrom the vector error correction model (VECM)



Std. Err.



[95% Conf.

































































Standarddiagnostic tests, for structural change and regression specification,were conducted during the process of estimation. The study used threelags which were best-fitting VEC regression specification. Findingsreveal that only the estimated error correction term in the firstcase is significant but with positive sign meaning that convergenceto the equilibrium state is not achieved in the long run. Allestimated error correction terms in all the three cases are also notstatistically significant. It follows then that each error correctionterm coefficient in all the cases points out that a deviation fromthe long-run equilibrium value in one period is not corrected withinthe next period by the size of that estimated coefficient.

Assuch, estimated results in table 1.5 above show that the short runrelationships among the three variables are not statisticallymeaningful and do not provide Granger causality. Accordingly, Masihand Masih (1996) opine that non-significance of the explanatoryvariables do not indicate a violation of the theory that explainsvarious relationships among the variables, because theory does notessentially dealwith the short term relationships.

1.2.620 year forecast

Thestudy made a 10 year forecast into the future with a view toestablish any causality or interactive relationship between oil priceand exchange rate and crude oil price using the VECM model. Findingsare as presented in figure 1.2 below.

Figure1.2: 20 year forecast for exchange rates in net exporting andimporting countries and Crude oil prices

Fromfigure 1.2 above, it can be established that over the next 20 years,there will be slight decline in exchange rates among net exportingcountries, while net importing countries will experience a steadydecline in their exchange rates. Crude oil prices will on thecontrary experience a sharp incline over the next 20 years. As such,it can be deduced that whereas exchange rates in net exporting andimporting countries will be moving quite closely together downwardsin over the next 20 years, crude oil prices will be independently onthe incline. Findings are as conducted at 95% confidence interval.



Thegeneral purpose of this particular study is to determine the overallrelationship between exchanges rates and oil prices. To accomplishthis, it became necessary to conduct research in ten countries (fiveoil importing countries and five oil exporting countries) which areactively involved in oil importation and exportation. With regards tothe relationship between oil prices and exchange rates, it isrealized that the dollar has always been the primary medium ofexchange when it comes to selling and trading oil internationally. Inthis, it is noted that if the value of dollar depreciates, theoverall price of oil, and by extension, demand tends to go up andvice versa. It, therefore, became necessary to conduct a 20 yearsdata study that will enable the study to come up with the requiredstatistics that will facilitate the understanding of the relationshipbetween oil prices and exchange rates. To provide an extensive andconcrete result, this study was able to utilizer –studio dataanalysis as a fundamental tool for establishing the requiredinformation so that there could be the proper understanding of thetopic under study. This chapter, therefore, reports on therecommendations and conclusion that resulted from this study.

Basedon the study conducted there are some critical factors that have beenable to lead to the variations and fluctuations in currency exchangerates. These factors include inflation rates, interest rates, thebalance of payments, government Debt, Terms of trade, politicalperformance and stability, recession, and speculations. Consideringthe fact that oil is usually priced regarding dollars, the generalexport revenue of oil-producing countries tends to predominantly theUS dollar. With regards to this, the depreciation of the dollar tendsto spark up a downward trend in the purchasing power of the oilrevenues. In this case, Oil producers opt to counterbalance thenegative effects of the depreciating dollar by increasing oil prices.Fluctuation in oil prices tends to affect the US dollar’s value andalso trade flows with regards to allocation of capital related to thetrade.All in all, it is realized that increases in oil prices meanthat oil producers tend to make more money and, as a result,importers tend to spend more than they save.

Fromtime to time, exchange rates are often noted to play a big role inmatters about the level of trade that a country can participate (bothimports and exports) which is a crucial factor in freest marketeconomies worldwide (Asari et al., 2011). It is for this reason thatmost investors and governments tend to watch exchange rates withclose interest to understand how poor or how well a particulareconomy is doing. Some governments, therefore, have been able tomanipulate the economic factors that influence their economies tohave a strong currency against the dollar. In most cases, volatileexchange rates tend to have the ability to hinder economic growth,prevent capital outflows, and even hurt the economy. Researchers andeconomists have been able to concur to the fact that oil price shocktends to contribute to most of the economic recessions that often hitthe world (Aziz, 2009). The un expected oil prices hike in 1973-1974an example of the factors that were able to result in theappreciation of the US dollar. (Aziz, 2009). This, therefore, raiseda question on whether there is a rational explanation for thebehavior in the foreign exchange market or it is based according towhat traders think? With this, the examination of the link betweenoil prices and exchange rate became a crucial element in answeringthe question.

Fromthe theory point of view, it was realized that oil exportingcountries tend to experience exchange rate appreciation when oilprices increase. On the contrary, they tend to experience exchangerate depreciation when there is an increase in the value of theirlocal currency and a decrease in oil prices. Studies have establisheda negative relationship between oil prices and exchange rates incountries that export oil. In other words, oil prices increase tocause an appreciation of the local currency in oil exportingcountries (Aziz 2009).

Tocome up with the answer to the raised issues related to exchangerates and oil prices, this study was able to investigate thevariables from the data collected using various approaches. Theseapproaches include The Vector Error Correction Model Approach,stationarity test, stability test, co-integration test, and Grangercausality test. The test conducted was able to determine therelationship between oil prices and exchange rates in net oilimporting and exporting countries. With this, the co-integrationbetween oil prices and exchange rates was determined. The data usedfor analysis was gathered from peer-reviewed sources and studiesconducted on the impact of oil shocks on exchange rates. The dataused covered a 20-year period, 1995 to 2014, which was obtained fromboth the board of governors of the federal reserve system (US)and theOrganization for Economic Co-operation and Development (OECD)database.

Findingand interpretations

Theresults from the vector error correction model that used the threelegs that were well best fitting in the vector error regressionspecification revealed that the merely approximated error correctionterm in the initial case was important in the study because it gavethe positive sign telling that the merging to the equilibrium statecannot be achieved in the long-run. The error estimation thatresulted from all the case used in this method is to importantstatistically. It shows that the error correction term coefficient inthe entire cases tells that a deviation from the long-run equilibriumvalue in one duration in not rectified in the next duration using theamount that is estimated by the coefficient used.

Formthe graphs used in figure 1.2, the future of the interactiverelationship between the exchange rate as well as the prices of theoil, and the price of the crude oil can be forecast using the VECMmodel. The results from the graphs are discussed below. From theforecasting graph for export using the VECM model discussed inchapter four, it can be noticed that the exchange rate for the exportwill have a positive gradient, this means that the will be anincrease in the rate of the for the exporters in the future. From thegraph of the forecast imports, it can be revealed that in the comingyears the importing will have a negative gradient, this means thatthe net exchange rate of the importing countries will go through asharp decrease in their rate of exchange. But for the crude oil, thenet rate of exchange will go through a steady increase in the future,the next twenty years, this graph shows a sharp positive gradientthat exhibits the explained results. It can be deduced from thegraphs in figure 1.2 that the rate of exchange in both the netimporting as well as the exporting countries will be having a closerrelationship that entails a gradual decline in the future, the nexttwenty years in this study. These findings that were carried out atninety-five percent confidence interval revealed that the exchange,contrary to the oil prices of the net importing as well as exporting,of prices of the crude oil will independently be on the increase inthe coming years. The VECM is an effective method because it hasrevealed that the future exchange rates of net importing as well asexporting countries can be forecasted.


Furtherstudy should be carried to show a deep relationship between theprices of the crude oil and the dollar to give a clearly described aswell as convincing theory. The theory should elaborate the coincidingmovement that exists between the exchange as well as the prices ofthe crude oil in the countries’ net importing as well as exporting.Since the empirical data in the research is not enough, the studyshould have concentrated on the data despite linking the rate ofexchange to the shocks from the oil. If a compressive and deep studyin this area is done effective, it could have revealed moreunderstandable as well as insightful results.

Thestudy should also bring out numerical data as well as supportivematerials such as the charts and graphs to give insightful details ofthe relation it seeks to elaborate. This numerical figures, as wellas pictorial presentation, will bring out the explicit relationshipbetween the oil price and the dollar currency.

Theresults revealed by the VECM model in this study can be used in theprediction of the future exchange rate of the net importing as wellas net exporting countries. Both the importing as well as exportingcountries should use the forecasted information to put the necessarymeasure in place to cope up this the changes that may arise due tothe fluctuation of the oil prices. The positive results forecastedfor the rate of exchange for the crude oil will be helpful to theimporting countries. The importing countries should use the positivecrude oil prices rather than invest of the price of the refined oilthat keeps on varying over the time.

Thetheoretical information discussed in this paper can be very helpfulto the country. The country should use the theoretical information ofthe factors affecting its exchange rate to make sure that this rateis favorable. The government should avoid government rate topreventing increase the revenues that might lead to increased demand.The interest rates of countries should be regulated to prevent anincreased exchange rates. It should be recommended that a countryshould regulate its rate of inflation to control the value of itscurrency.

Thetheoretical impact of the exchange rate in countries should be takenwith a lot of seriousness to help the countries control the price ofthe oils. The information on the relationship between exchange rateand the oil price should be analyzed to help the affected nation comeup with the policy of ensuring there is a balance between the two.

Theresults obtained from the study on the appreciation of rate exchangeas well as depreciation exchange can be used by the countriesproducing oil to prevent negative effects that may arise as a resultof these changes. This can help the oil producing countries not todepend fully on the revenue obtained from the oil by investing inother areas to prevent any form of financial crisis that may affectthe country due to the depreciation of the rate of exchange as aresult of increases in the prices of oil.

Theoil producing countries that go through the turmoil of politicalinstability should avoid such political unrest. This is because oilsuppliers respond by increasing their bid on the cost of the oilproduct. therefore, the highest buyer takes to control the oil supplybusiness in that republic. Price upsurges in oil due to the insightthat there is a decline in oil supply, even if the cost of oilproduction may remain constant. The peace stability as well politicalstability in this countries can help in the in the regulation of theprices of the oil, that will go hand in hand with control of theexchange, this can cause the country to have a stable exchange rate.This will prevent the country from facing the challenges ofdepreciation.

Thispaper also recommends that various government should avoid by allmeans nay form of the debt. The more a government has foreign debt,the more the exchange rate of that country is influenced. Thisbecause the oil price has a direct impact on the dollar currency thataffects the currencies of countries importing oil as well as thecountries exporting the oil product. Avoidance of these debts willbring a country a stable rate of exchange because the governmentswill accrue the foreign capital causing these countries to experiencethe high rate of inflation.

Theresearch in this study can be very help to the scholars pursuing therelationship between the oil price as well as the rate of exchange.This will help them to understand the main factors that affect therate of exchange of a certain country. It provides both theoreticalas well as empirical information that will help the students torelate the relationship that exists between the exchange rate and oilprices. When used by the students, it provides good methods ortechniques for analysis data in this area.


Fromthe study, it can be revealed that the dollar currency is the oiltrading currency hence, any fluctuation in the currency affects theprices of the crude oil. There are strong relationships that existbetween the dollar currency and the prices of the energy. From theabove research, it is revealed that the since 2002, raises at theprices of the oil has brought value depreciation of the dollarcurrency. Hence, the countries that hinge on the economies of energyshow an essential potion on the trade of balance. is evident fromthis study that countries with small open economies, as well as theirexchange rates, are floating, go through an important effect on thevalue of their money when they are importing as well as exporting theoil. Therefore, the prices of the oil upsurge the income of thecountries exporting the oil, as well as low the income of thecountries that are importing the oil. Over the past years, the studyrevealed that the trend of the oil prices has precipitatedfluctuations in the rate of exchange trends both in the economies ofexporting as well as importing oil.

Fromthe collected data, it was revealed that exchange rates have a hugeessential effect on the value of goods and services that are importedas well as exported. The prices of the imports and export of aparticular country have a significant consequence of the rate ofexchange. Likewise, the energy affects the production of goods inmany important ways. Due to the increase in the price of petroleumproducts in 2009, the supplies from the field of agriculture haveoverwhelmingly increased as the result of the increase in the pricesof energy. It can be said from the above result, the price ofcommodities obtained from production is directly proportional to theprices of the energy related product, especially the products fromthe oil. The changes in the prices of the oil variables have thesubstantial impact on the establishment of the risk management plansas well as developing of the decision based on the long-termobjectives of a given company.

Fromthe finding of non-stationarity in the series, it can be concludedthat at the level form, the statistics were greater than the givencritical values of the all the equation. This indicated there was notrend that had a constant only as well as no constant or trend thatshowed both the trend as well as the constant of the results. Fromthe result of the stationary test, it revealed that the unit rootexisted in all the tools at the level form of each model. It was alsonoted that the conversion of the variables to their first differenceforms showed all the variable became stationary as well as can beperceived as integrated into the form of one order.

Thisstudy also examined the factors that influence the foreign exchangerate of a given country. It was found that the inflation rates that acountry experience in the market inflation influences the exchangerate of the currency. It is concluded that the countries with lowrate of inflation as compared to others, witness increases in thevalue of their currency. Another factor revealed to be influencingthe exchange rate of a country is the interest rates, it wasconcluding that the variations in the interest rates have an impacton the dollar exchange rate as well as the value of currency for aparticular country. Another factor found to be affecting the exchangerate is the government debt, it was found that from the theoreticalframework the nations accrue foreign capital as a result of thegovernment debt causing the value of the nation’s exchange ratedecrease. Terms of trade were found to be influencing the exchangerate of a particular country, high terms of trade cause the increasein the country’s revenues that have an increased impact on thedemand for then currency.

Fromthe theoretical framework of the study, it has been confirmed that anincrease in the prices of the oil has a proportional impact on theproduction cost for the firms of a country. This kind of increase cancause an upsurge in the production cost of the non-tradable products.This confirmed that the above effect is an appreciation of the rateof exchange caused by the increase in the prices of the non-tradable.According to the perception of demand, the study showed the rate orexchange is inversely proportional the relationship it has with thedisposable income. From the research, an upsurge in the prices of oildecreases the consumer’s power of spending. Therefore, the demandfor the non-tradable goods will be low causing a decrease in thespending power of the consumers, as well as a decline in the cost ofproducts that will cause a decrease in the value of country’scurrency.

Finally,the study has concluded that the appreciation of exchange rate in thecountries exporting oil occurs when the prices of oil increases, aswell as depreciation of the exchange rate, is as a result of thedecrease in the prices of oil. Therefore, in the countries with theoil reserves, the value of the currency increases about the statesthat do not possess the reserves of oil once there is a rise in theprices of oil. From the study, this was indicated to happen in Asiaafter the prices of the oil decreased causing a financial crisis inthe Asian countries, such as Russia.


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