The Impact of Exchange Rate Data on Canadian Inflation: An FPCA and Group LASSO Approach

Abstract

This study investigates the temporal dynamics of exchange rates between various international currencies and the Canadian dollar, with a focus on understanding how these rates influence Canadian inflation. The Functional Principal Component Analysis (FPCA) is applied to effectively reduce the dimensionality of exchange rate data and capture important modes of variation. The extracted functional principal components (FPCs) were then used in a Group LASSO regression model to identify which currencies most significantly impact inflation rates in Canada. Our analysis includes exchange rates from nine countries. The results show that the U.S. Dollar (USD), Mexican Peso (MXN), and Swedish Krona (SEK) are the most influential currencies in predicting Canadian inflation rates. By employing these advanced statistical techniques, this study provides a comprehensive assessment of how fluctuations in global currencies can affect the domestic economic environment, offering valuable insights for policymakers and financial analysts. This study contributes to the broader understanding of currency exchange impacts on inflation and highlights the importance of specific international currencies in economic forecasting.