Simple Cross-Check Models for the Krone Exchange Rate

Abstract

In this paper we discuss simple cross-check models for the krone exchange rate. Such models may give information as to whether the exchange rate is in line with basic macroeconomic fundamentals. Norges Bank publishes forecasts for several variables, e.g. the interest rate, inflation, the output gap and the exchange rate. General equilibrium models are important tools in the forecasting process. However, as stated by Deputy Governor Jarle Bergo, “…There is no mechanical relationship between the models the Bank uses and its forecasts…Central to this process is the use of judgement…” (Bergo, 2006). Cross-checks are useful tools in the forecasting process as they may provide additional information not necessarily captured by the bank’s macro models. First, we look at the evolution of the real exchange rate since the beginning of the 1970s. If the real exchange rate is stationary, the future exchange rate can be predicted on the basis of deviation from Purchasing Power Parity (PPP). Second, we discuss some simple econometric models where the exchange rate is determined by variables like the price and interest rate differential relative to Norway’s trading partners and the oil price.