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Spurious Correlation in Exchange Rate Target Zone Modelling: Testing the Drift Adjustment Method on the US Dollar, Random Walk and Chaos

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  • Darvas, Zsolt

Abstract

The drift-adjustment method estimates the expected rate of depreciation within an exchange rate band by simple equations. Papers applying this method claim that, while forecasting a freely floating currency is hopeless, predicting an exchange rate within the future band is successful. This paper shows that the results achieved by applications to EMS and Nordic currencies are not specific to data of target zone currencies. For example, application to US dollar leads qualitatively to the same result as application to EMS currencies. Simulation evidence suggests that the closer the dominant inverted autoregressive root to unity the higher the chance of reproducing the empirical target zone results, since the finite sample biases of the parameters of interest in the unit root case are such that the random walk seemingly significantly fits the model in the vast majority of experiments. HAC standard errors do not help much in hypothesis testing either. The paper develops a simple model coinciding with stylized facts of target zones that demonstrates the unpredictability of the expected rate of depreciation within the band. Surprisingly, application of drift-adjustment method to a process switching between stationary periods and chaotic periods, the fit is similar to reported target zone results.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1890.

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Date of creation: May 1998
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Handle: RePEc:cpr:ceprdp:1890

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Keywords: exchange rate traget zone; Monte Carlo simulation; Unit Root;

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Cited by:
  1. Francisco Ledesma-Rodriguez & Manuel Navarro-Ibanez & Jorge Perez-Rodriguez & Simon Sosvilla-Rivero, 2005. "Assessing the credibility of a target zone: evidence from the EMS," Applied Economics, Taylor & Francis Journals, vol. 37(19), pages 2265-2287.
  2. C. Paul Hallwood & Ian W. Marsh, 2003. "Exchange Market Pressure on the Pound-Dollar Exchange Rate: 1925-1931," Working papers 2003-23, University of Connecticut, Department of Economics.
  3. Darvas, Zsolt, 1999. "Az árfolyamsávok empirikus modelljei és a devizaárfolyam sávon belüli előrejelezhetetlensége
    [Empirical models of exchange rate target zones]
    ," Közgazdasági Szemle (Economic Review - monthly of the Hungarian Academy of Sciences), Közgazdasági Szemle Alapítvány (Economic Review Foundation), vol. 0(6), pages 507-529.
  4. Zsolt Darvas & Gábor Rappai & Zoltán Schepp, 2007. "Uncovering Yield Parity: A New Insight into the UIP Puzzle through the Stationarity of Long Maturity Forward Rates," Money Macro and Finance (MMF) Research Group Conference 2006 84, Money Macro and Finance Research Group.
  5. Syed Adnan Haider Ali Shah Bukhari & Muhammad Shahbaz Akmal & Mohammad Sabihuddin Butt, 2006. "Impact of Exchange Market Forces on Pak-Rupee Exchange Rates during Globalization Period: An Empirical Analysis," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 11(1), pages 121-139, Jan-Jun.
  6. Francisco Ledesma-Rodriguez & Manuel Navarro-Ibanez & Jorge Perez-Rodriguez & Simon Sosvilla-Rivero, 2000. "On the Credibility of the Irish Pound in the EMS," The Economic and Social Review, Economic and Social Studies, vol. 31(2), pages 151-172.

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