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A Model of Stochastic Process Switching

Robert Flood () and Peter Garber

No 626, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: In this paper we develop a rational expectations exchange rate model which is capable of confronting explicitly agents' beliefs about a future switch in exogenous driving processes. In our set-up the agents know with certainty both the initial exogenous process and the new process to be adopted when the switch occurs. However, they do not know with certainty the timing of future switch as it depends on the path followed by the (stochastic) exchange rate. The model is discussed in terms of the British return to pre-war parity, in 1925. However, our results are applicable to a variety of situations where process switching depends on the motion of a key endogenous variable.

Date: 1981-02
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Published as Flood, Robert P. and Peter M. Garber. "A Model of Stochastic Process Switching." Econometrica, Vol. 51, No. 3, (May 1983), pp. 537-552.

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