Working Paper: CEPR ID: DP522
Authors: Kenneth Froot; Maurice Obstfeld
Abstract: Simple techniques of regulated Brownian motion are used to analyse the behaviour of the exchange rate when official policy reaction functions are subject to future stochastic changes. We examine exchange rate dynamics in cases where the authorities promise (i) to confine a floating rate within a predetermined range, (ii) to peg the currency once it reaches a predetermined future level, and (iii) to unify a system of dual exchange rates. Similarities between these and several related examples of regime switching are stressed. We also discuss how stochastic regime changes can affect some standard statistical tests of hypotheses about exchange rates.
Keywords: regime change; target zone; regulated brownian motion
JEL Codes: 431
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Authorities' promise to confine a floating rate within a predetermined range (E43) | Exchange rate dynamics reflect this policy (F31) |
| Authorities peg the currency once it reaches a predetermined future level (F31) | Exchange rate exhibits different dynamics compared to a permanent float (F31) |
| Anticipated unification of a system of dual exchange rates (F31) | Shifts in exchange rate behavior (F31) |
| Extreme values of interest rates, current accounts, inflation, or exchange rates (F31) | Policy changes (J18) |
| Policy changes (J18) | Behavior of forward-looking variables (C29) |