Exchange Rate

Discussion Papers No. 340, February 2003
Statistics Norway, Research Department
Hilde C. Bjørnland and Håvard Hungnes
The importance of interest rates
for forecasting the exchange rate
Abstract:
This study compares the forecasting performance of a structural exchange rate model that combines
the purchasing power parity condition with the interest rate differential in the long run, with some
alternative models. The analysis is applied to the Norwegian exchange rate. The long run equilibrium
relationship is embedded in a parsimonious representation for the exchange rate. The structural
exchange rate representation is stable over the sample and outperforms a random walk in an out-ofsample
forecasting exercise at one to four horizons. Ignoring the interest rate differential in the long
run, however, the structural model no longer outperforms a random walk.
Keywords: Equilibrium real exchange rate, cointegration VAR, out-of-sample forecasting
JEL classification: C22, C32, C53, F31
Acknowledgement: The authors wish to thank Å. Cappelen, P. R. Johansen and T. Skjerpen for
very useful comments and discussions. The usual disclaimers apply.
Address: Hilde C. Bjørnland, University of Oslo and Statistics Norway.
E-mail: [email protected].
Håvard Hungnes, Statistics Norway, Research Department. E-mail: [email protected]
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