The Importance of Interest Rates for Forecasting the Exchange Rate

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 exchange rate models. The analysis is applied to the Norwegian exchange rate. The long-run equilib-rium 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-of-sample forecasting exer-cise at one to four horizons. Ignoring the interest rate differential in the long run, however, the structural model no longer outperforms a random walk. Copyright © 2006 John Wiley & Sons, Ltd. key words equilibrium real exchange rate; purchasing power parity; cointe-grated VAR; out-of-sample forecastin