The exchange rate in the CNB´s forecasting system

The relatively small and open Czech economy is strongly affected by external factors. These include changes in the prices of energy-producing raw materials and the economic situation of the Czech Republic's major trading partners. The koruna's exchange rate also plays an important role.

The CNB's overall macroeconomic forecast includes a forecast for the koruna-euro nominal exchange rate. In addition to the nominal exchange rate, which above all influences import prices, the real exchange rate - i.e. the exchange rate adjusted for changes in the price levels in the Czech Republic and the foreign economy in question - plays a vital role. The real exchange rate enters the forecast in the form of the exchange rate component of the monetary conditions (see the April 2004 Inflation Report), which equals the difference between the real exchange rate and its equilibrium value. The equilibrium value of the exchange rate at a given moment is the value that would be observed if the economy did not deviate from its equilibrium as a result of various larger or smaller shocks. The evolution of the equilibrium rate over time is determined by economic factors and lies beyond the reach of monetary policy, whereas the actual real (and nominal) exchange rate can be influenced by monetary policy instruments at least to some degree.

The equilibrium real exchange rate is not a directly measurable variable. However, we can assume, for instance, that it is close to the long-term trend of the actual real exchange rate. In practice, the trend of the relevant time series is often calculated using various "filtering methods", which "filter out" short-term fluctuations from the time series of the given variable. To estimate the equilibrium real exchange rate (as well as the equilibrium values of other variables), the CNB uses a multivariate filtering method known as the Kalman filter. This is a type of filtration based on information about the structure and operation of the economy. It thus incorporates a model of the linkages between the filtered variable and a number of other important macroeconomic variables (which is why we speak of a "multivariate" filter), therefore yielding better results than other, purely mathematical and univariate methods, which work only with the filtered variable itself. By including information about the structure of the linkages between the filtered variable and the rest of the economy, we eliminate, inter alia, the problems that arise at the ends of time series when using univariate filtering methods.

The central equation of the filtering approach used in the CNB's forecasting system assumes that the real exchange rate trend (z_eq t+4 - z_eqt ) corresponds to the trend in interest rates, namely the domestic 1Y PRIBOR (r_eq ) and the foreign 1Y EURIBOR (r_eq *). Moreover, the trend is adjusted for the risk premium ( prem_eq). In economics, the relation is generally referred to as real uncovered interest parity:

z_eqt+4 - z_eqt = r_eq*t - r_eqt + prem_eqt.

In addition to uncovered interest parity, the other starting points for estimating the longterm equilibrium real exchange rate are simulated scenarios of the convergence of the Czech economy towards the advanced European economies.