DP522 Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach

Author(s): Kenneth Froot, Maurice Obstfeld
Publication Date: February 1991
Keyword(s): Regime Change, Regulated Brownian Motion, Target Zone
JEL(s): 431
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=522

Simple techniques of regulated Brownian motion are used to analyse the behaviour of the exchange rate when official policy reaction functions are subject to future stochastic changes. We examine exchange rate dynamics in cases where the authorities promise (i) to confine a floating rate within a predetermined range, (ii) to peg the currency once it reaches a predetermined future level, and (iii) to unify a system of dual exchange rates. Similarities between these and several related examples of regime switching are stressed. We also discuss how stochastic regime changes can affect some standard statistical tests of hypotheses about exchange rates.