Usingarealexchangeratemodeltomakerealandnominalforecasts.docVIP

Using a real exchange rate model to make real and nominal forecasts Peter Sellin( Sveriges Riksbank November 2006 Abstract In this paper we evaluate the forecasting performance of a real exchange rate model applied to the Swedish Krona’s real and nominal effective exchange rate, as well as the bilateral exchange rates against the US and the Euro area and the implicit USD/EUR exchange rate. The theoretical model implies a cointegrating relation between the real exchange rate, relative output, terms of trade and net foreign assets. The vector error correction model’s forecast performance is quite satisfactory for most of these exchange rates once the dynamics of the model have been augmented with an interest rate differential. JEL classification: C52, C53, F31. Keywords: real exchange rate, nominal exchange rate, forecasting. 1 Introduction A standard inter-temporal open economy model typically finds that the steady-state real exchange rate is related to the relative productivity in the tradables sector, the terms of trade and the net foreign asset position (see for example Lane and Milesi-Ferretti (2004) and Obstfeld and Rogoff (2004)). In this paper we will test if forecasts from a vector error correction model based on the Lane and Milesi-Ferretti (2004) model can beat a random walk at horizons of 1 to 12 quarters. A simple extension of the empirical model allows us to consider forecasts of the nominal as well as the real effective exchange rate. We also forecast the effective exchange rate indirectly as a weighted average of forecasts of the SEK/EUR and SEK/USD exchange rates. Finally, we evaluate the implicit forecast of the USD/EUR exchange rate. We find that the model forecasts are quite satisfactory once the dynamics of the model have been properly specified. The out-of-sample forecasting performance of exchange rate models poses a special challenge to open economy macroeconomists. The standard finding in the empirical literature, starting with the seminal ar