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Exchange rate instability: determinants and predictability

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  • Richard A. Meese
  • Andrew K. Rose

Abstract

The paper is concerned with exchange rate instability, by which we mean large changes in exchange rates. The paper has two objectives. First, we search for plausible determinants of currency crashes. To do this we examine annual panel data for a large sample of developing countries. The work is non-structural, taking the form of probit regressions which link currency crashes to a variety of candidate causes. We examine a comprehensive set of both foreign and domestic explanatory variables. The list includes: foreign conditions; the vulnerability of the country to a crash; the level of external indebtedness; the composition of this debt; measures of domestic government policy; and measures of the state of well-being of the economy. The second objective of the paper is to examine the predictability of exchange rate crashes. For this, we use quarterly time series data from eight countries in the European Monetary System to calibrate two structural models of speculative currency attacks. The first model relies on a traditional monetary approach to exchange rate determination in a target zone, and the second uses a Markov-switching model with time-varying transition probabilities. Both models are calibrated using nontraditional methods to determine model parameters, as we are primarily interested in our models' ability to predict the exchange rate regime that will prevail in the next quarter. In consonance with the older literature on empirical exchange rate models, we do a reasonable job in-sample of predicting currency crises, but a very poor job of forecasting currency crises one quarter ahead.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Pacific Basin Working Paper Series with number 97-03.

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Date of creation: 1997
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Publication status: Published in Managing capital flows and exchange rates : perspectives from the Pacific basin (Cambridge University Press, 1998)
Handle: RePEc:fip:fedfpb:97-03

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Keywords: Foreign exchange rates ; Financial crises;

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Cited by:
  1. Gourinchas, Pierre-Olivier & Landerretche, Oscar & Valdés, Rodrigo, 2001. "Lending Booms: Latin America and the World," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2811, C.E.P.R. Discussion Papers.
  2. Socorro Gochoco-Bautista, Maria, 2000. "Periods of Currency Pressure: Stylized Facts and Leading Indicators," Journal of Macroeconomics, Elsevier, Elsevier, vol. 22(1), pages 125-158, January.
  3. Frank Agbola & Chartri Kunanopparat, 2005. "Determinants of exchange rate practices: some empirical evidence from Thailand," Applied Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 37(7), pages 807-816.
  4. Rodrigo O. Valdés & Ilan Goldfajn, 1997. "Are Currency Crises Predictable?," IMF Working Papers 97/159, International Monetary Fund.
  5. Kruger, Mark & Osakwe, Patrick N. & Page, Jennifer, 1998. "Fundamentals, Contagion and Currency Crises: An Empirical Analysis," Working Papers, Bank of Canada 98-10, Bank of Canada.
  6. von Hagen, Jurgen & Zhou, Jizhong, 2005. "De facto and official exchange rate regimes in transition economies," Economic Systems, Elsevier, vol. 29(2), pages 256-275, June.
  7. von Hagen, Jürgen & Zhou, Jizhong, 2002. "The choice of exchange rate regimes: An empirical analysis for transition economies," ZEI Working Papers B 03-2002, ZEI - Center for European Integration Studies, University of Bonn.

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