The exchange rate path in the g3 model
The exchange rate path in the g3 model is determined primarily by the uncovered interest parity condition. According to this condition, the current exchange rate level is determined by the expected exchange rate level and the size of the interest rate differential between the domestic and foreign interest rate adjusted for the risk premium. The expected exchange rate is determined in a model-consistent manner and depends on both the endogenous and exogenous variables of the model. The risk premium takes into account short-term exchange rate volatility and the trend reflecting the stock of net external assets, with, for example, a higher debt ratio of the domestic economy resulting in an increase in the risk premium and exerting depreciation pressures on the currency.
In the Czech economy, however, the uncovered interest parity condition fails to describe sufficiently the observed movements of the exchange rate, which in reality shows some persistence. In the g3 model, therefore, the uncovered interest parity condition is adjusted to include a certain degree of stickiness. Although this adjustment is not based on microeconomic foundations, it helps us to replicate the real data, as it was calibrated by comparing the model characteristics with the observed data.
The exchange rate forecast for the first quarter of the forecast is additionally adjusted based on the results of simulations of satellite models that use a wider set of short-term information than the core model and based on the recent values of the exchange rate.