Oil Money: Short-term Exchange Rate Prediction of the Norwegian Krone

Abstract

Earlier research has suggested a non-linear relationship between the Brent crude oil price and the Norwegian krone. This was proven by constructing a dynamic monetary exchange rate model that outperformed adrift less random walk model at short term out-of-sample forecasting.These results contradict much of the literature on exchange rate modeling, and for the Norwegian krone, at least, they reject the infamous Meese-Rogoff puzzle. It is worth noting that this research was conducted on a mix of fixed and managed floating exchange rate regimes, whilst the Meese-Rogoff puzzle was derived from a period of floating exchange rates following the collapse of the Bretton Woods agreement.Our research on the other hand is conducted on a floating krone exchange rate. Its hows that dynamic equilibrium-correction models, following the monetary approach and including the oil price as a predictor,are able to outperform a drift less random walk model at short term out-of-sample forecasting of the EURNOK exchange rate in terms of root mean square errors. Wealso find that the oil price is an efficient predictor of the krone exchange rate, and that the predictive power of the oil price is stronger when dependent on falling oil prices.That is, we find asymmetric oil price effects. Consequently, it is concluded that there is evidence for a non-linear oil price-krone relationship. Lastly, we only find evidence for short term oil price effects on the exchange rate. This is consistent with previous research on the topic.