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Stochastic Process Switching: Some Simple Solutions

  • Froot, Kenneth A
  • Obstfeld, Maurice

When changes in the economic policy regime occur stochastically, asset prices will reflect the possibility of such shifts. In this paper we apply techniques of regulated Brownian motion to obtain closed-form analytic price solutions when policy reaction functions are subject to prospective changes. We focus on the case in which the authorities promise to peg a currency's exchange rate once it reaches a predetermined future level. We also show how an open-ended commitment to exchange-rate targeting may lead to multiple equilibria.

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Article provided by Econometric Society in its journal Econometrica.

Volume (Year): 59 (1991)
Issue (Month): 1 (January)
Pages: 241-50

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Handle: RePEc:ecm:emetrp:v:59:y:1991:i:1:p:241-50
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  1. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August.
  2. Maurice Obstfeld & Alan C. Stockman, 1983. "Exchange-Rate Dynamics," NBER Working Papers 1230, National Bureau of Economic Research, Inc.
  3. Klein, Michael W, 1990. "Playing with the Band: Dynamic Effects of Target Zones in an Open Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(4), pages 757-72, November.
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