Abstract
The existing literature treats the exchange rate within the band as an unbounded continuous variable. The exchange rate within a target zone is a bounded variable censored beyond the upper and lower band margins. If the censored nature of the exchange rate is ignored the parameter estimates will be biased. The confidence intervals for expected realignment will reflect this bias and distort the result of credibility tests.
The limited dependent variable rational expectations model integrates this feature of the exchange rate mechanism into the estimation process. Moreover, it explicitly models expectations of economic agents who will incorporate the bounded nature of the data into their information sets when forming expectations about exchange rate movements.
I find considerable support for modeling the exchange rate using
limited dependent variable framework. My results indicate that
accounting for the band in the drift adjustment method significantly
modifies the results of credibility tests. As opposed to earlier
findings in the literature, confidence intervals for the expected
realignment are wider than those resulting from ordinary least squares
estimates and from a rational expectations model obtained without
imposing the band. Furthermore, my results trace the history of the
ERM realignments for the FF/DM and in each case correctly identify the
period before and after a realignment as a period lacking
credibility. The model predicts a gradual widening of confidence
intervals after 1980 until the end of 1990. Although a zero expected
realignment is contained in the confidence intervals for most of this
period, the widening of the interval also suggests a tension building
up with possibly larger realignment sizes.