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Testing the Bounds: Empirical Behavior of Target Zone Fundamentals

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Abstract

Standard target zone exchange rate models are based on nonlinear functions of an unobserved economic fundamental, which is assumed to be bounded, similarly to the target zone exchange rates themselves. A violation of this key assumption is a basic structural reason for model failure. Using a novel estimation and testing strategy, we show it is also a testable assumption. Our empirical results cast serious doubt on its validity in practice, providing a primitive reason for well-documented rejections of the basic model. Model failure from this violation is robust to otherwise ideal circumstances (e.g., perfect credibility).

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  • J. Isaac Miller, 2008. "Testing the Bounds: Empirical Behavior of Target Zone Fundamentals," Working Papers 0803, Department of Economics, University of Missouri, revised 15 Apr 2009.
  • Handle: RePEc:umc:wpaper:0803
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    Keywords

    target zone exchange rates; economic fundamental; unscented Kalman filter; rescaled range statistic;

    JEL classification:

    • F3 - International Economics - - International Finance
    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling

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