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An Empirical Reassessment of Target-zone Nonlinearities

  • Garratt, Anthony
  • Psaradakis, Zacharias
  • Sola, Martin

This paper investigates the presence of target-zone nonlinearities in the Pound Sterling/Deutsche Mark exchange rate for the period of the UK European Exchange Rate Mechanism (ERM) membership, using data with frequency of every two days. Tests against general nonlinear specifications as well as specifications consistent with a stochastic devaluation risk model of exchange rate target zones are carried out using recursive techniques. In addition, the significance of nonlinear effects is analysed within a recursive Bayesian frame-work. The authors find evidence of target-zone nonlinearities in the whole sample, but the recursive analysis yields support for the presence of such nonlinearities only in specific subsamples. The results imply that the reductions in the UK inflation was most likely a consequence of contractionary policies rather than of the expectational effects of the target zone.

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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 9825.

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Date of creation: Nov 1998
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Handle: RePEc:cam:camdae:9825
Contact details of provider: Web page: http://www.econ.cam.ac.uk/index.htm

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  1. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, vol. 80(2), pages 192-96, May.
  2. Froot, Kenneth & Obstfeld, Maurice, 1991. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," CEPR Discussion Papers 522, C.E.P.R. Discussion Papers.
  3. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August.
  4. Francis X. Diebold & James M. Nason, 1989. "Nonparametric exchange rate prediction?," Finance and Economics Discussion Series 81, Board of Governors of the Federal Reserve System (U.S.).
  5. Bertola, Giuseppe & Svensson, Lars E O, 1991. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," CEPR Discussion Papers 513, C.E.P.R. Discussion Papers.
  6. Richard A. Meese & Andrew K. Rose, 1989. "An empirical assessment of non-linearities in models of exchange rate determination," International Finance Discussion Papers 367, Board of Governors of the Federal Reserve System (U.S.).
  7. Donald W.K. Andrews, 1990. "Tests for Parameter Instability and Structural Change with Unknown Change Point," Cowles Foundation Discussion Papers 943, Cowles Foundation for Research in Economics, Yale University.
  8. Rose, Andrew K & Svensson, Lars E O, 1991. "Expected and Predicted Realignments: The FF/DM Exchange Rate During the EMS," CEPR Discussion Papers 552, C.E.P.R. Discussion Papers.
  9. Donald W.K. Andrews & Werner Ploberger, 1992. "Optimal Tests When a Nuisance Parameter Is Present Only Under the Alternative," Cowles Foundation Discussion Papers 1015, Cowles Foundation for Research in Economics, Yale University.
  10. Flood, Robert P. & Rose, Andrew K. & Mathieson, Donald J., 1991. "An empirical exploration of exchange-rate target-zones," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 35(1), pages 7-65, January.
  11. Fitzenberger, Bernd, 1998. "The moving blocks bootstrap and robust inference for linear least squares and quantile regressions," Journal of Econometrics, Elsevier, vol. 82(2), pages 235-287, February.
  12. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
  13. Thursby, Jerry G, 1982. "Misspecification, Heteroscedasticity, and the Chow and Goldfeld-Quandt Tests," The Review of Economics and Statistics, MIT Press, vol. 64(2), pages 314-21, May.
  14. Donald W.K. Andrews & Christopher J. Monahan, 1990. "An Improved Heteroskedasticity and Autocorrelation Consistent Covariance Matrix Estimator," Cowles Foundation Discussion Papers 942, Cowles Foundation for Research in Economics, Yale University.
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