Testing the Bounds: Empirical Behavior of Target Zone FundamentalsNo 803, Working Papers from Department of Economics, University of Missouri Abstract: Standard target zone exchange rate models are based on a nonlinear function of an unobserved economic fundamental, which is defined as the log of the domestic money stock plus exogenous velocity shocks that are generally assumed to follow a random walk. A critical and widespread assumption in the literature is that this fundamental is bounded, similarly to the target zone exchange rates themselves. We use seven techniques to estimate the unobserved fundamentals driving a wide variety of exchange rates that have traded under target zone regimes at different times over the past two decades. Two of these techniques involve a nonlinear filter that is not well-known to econometricians, but which has clear advantages over more well-known filters. We then test the estimated fundamentals for unboundedness, using non-standard unit root tests that have recently been shown to have good power against bounded, nonlinear alternatives. Finally, we use maximum deviations of the estimated fundamentals to show that de facto empirical bands on these estimates generate implausible elasticities. Our empirical results cast serious doubt on the theoretical assumption that such fundamentals are bounded. Keywords: target zone exchange rates; economic fundamental; Kalman filter; unscented Kalman filter; rescaled range statistic (search for similar items in EconPapers) Downloads: (external link) Related works: Access Statistics for this paper More papers in Working Papers from Department of Economics, University of Missouri |
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