31 IRP, expectations and forecast error Assume that interest rate parity exists and will continue to exist in the future. Assume that the interest rates of Australia and New Zealand vary substantially in many periods.

You expect that interest rates at the beginning of each month have a major effect on the New Zealand dollar’s exchange rate at the end of each month because you believe that capital flows between Australia and New Zealand influence the New Zealand dollar’s exchange rate. You expect that money will flow to whichever country has the higher nominal interest rate. At the beginning of each month, you will either use the spot rate or the one-month forward rate to forecast the future spot rate of the New Zealand dollar that will exist at the end of the month. Will the use of the spot rate as a forecast result in smaller, larger or the same mean absolute forecast error as the forward rate when forecasting the future spot rate of the New Zealand dollar on a monthly basis? Explain.