The Power of Interest Rates. : The NOK/Euro Exchange Rate Under an Inflation Targeting Regime.

Abstract

The goal of this thesis is to investigate how different factors have an impact on the exchange rate between Norwegian kroner and euro during the inflation targeting regime. This thesis uses a study by Bjørnstad and Jansen (2007) called “The NOK/euro exchange rate after inflation targeting: The interest rate rules” as both a starting - and reference point throughout the paper. Bjørnstad and Jansen investigate how a monetary regime shift affects the exchange rate in a small open economy. Their focus is on Norway and their transition from a fixed exchange rate targeting regime to an inflation targeting regime.

Several previous studies of exchange rate determination in an inflation targeting regime have been using data containing different monetary policy regimes. In this thesis it will be investigated if the same effects can be found using data containing an inflation targeting monetary regime only. The data used is a sub sample of the data sample made by Bjørnstad and Jansen, which solely contains inflation targeting monetary policy in the years from 2001 to 2009. It will be looked into how the Bjørnstad and Jansen model, and later a new model, works on the sub sample. How these models perform during the financial crisis in 2008 and 2009 is also a topic.

The last large change in Norwegian monetary policy came in March 2001, when Norway adopted an inflation target. The monetary exchange rate regime Norway has today is a result of economic evolution and several reforms of the monetary systems over the last 100 years. Norway has gone from a fixed exchange rate against a silver standard in the end of the 19th century, to floating exchange rate with an inflation target in the beginning of the 21st century. This transition has been influenced and dictated both by events happening in Norway and events happening with their trading partners. The development of the different Norwegian monetary regimes through history, as well as the events which made this happen, are briefly reviewed in the second section of this paper.

There exist several empirical studies in the field of exchange rate determination. In this thesis a few of these studies are briefly discussed, among them the earlier mentioned study by Bjørnstad and Jansen. These empirical findings represent the results after trying to model exchange rate development on different monetary regimes. The model by Bjørnstad and Jansen has been replicated and its performance, both when the data sample is extended and a different sub sample has been used, has been thoroughly explored. A quick out-of-sample forecasting competition between the model by Bjørnstad and Jansen and a random walk model has also been done. One finding is that the Bjørnstad and Jansen model experience trouble when it comes to both explaining and forecasting the financial crisis.

The model by Bjørnstad and Jansen also contain some positive qualities that deserve to be investigated further. In the light of this, a new model on exchange rate determination under an inflation targeting regime is established. A sub sample of the data set by Bjørnstad and Jansen which only contain the years from 2001 to 2009 has been used. In this paper it is found that the major explanatory factors in exchange rate determination is the interest rate differential between Norway and Europe and in specific the interest rate development in Norway. The new model, in similarity with the Bjørnstad and Jansen model, do not predict the financial crises. Thus, the conclusion to this problem is that the events that determined the exchange rate during the financial crisis are exceptional circumstances which disturb the relationship between the variables.