The Distribution of Exchange Rates in the EMS

36 Pages Posted: 24 Nov 2000 Last revised: 18 Sep 2022

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Craig S. Hakkio

Federal Reserve Bank of Kansas City

Date Written: August 1994

Abstract

Exchange rates of currencies in the Exchange Rate Mechanism of the EMS are characterized by long periods of stability interrupted by periods of extreme volatility. The periods of volatility appear at times of realignments of the central parities and at times when the exchange rate is within the ERM bands. We begin by considering a procedure for finding outliers based on measuring distance as a quadratic form. The evidence suggests that the exchange rates of the EMS can be described by a mixture of two distributions. We therefore model the exchange rate as switching between two distributions--one that holds in stable times and the other that holds in volatile times. In particular, we use Hamilton's Markov-switching model. In addition, we extend Hamilton's model by allowing the probability of switching from one state to another to depend on the position of the exchange rate within its EMS band. This model has the interesting implication that near the edge of the band, large movements--either realignments or large jumps to the center of the band--are more likely if the move to the edge of the band has been precipitous.

Suggested Citation

Engel, Charles M. and Hakkio, Craig S., The Distribution of Exchange Rates in the EMS (August 1994). NBER Working Paper No. w4834, Available at SSRN: https://ssrn.com/abstract=250355

Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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University of Washington - Department of Economics ( email )

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Craig S. Hakkio

Federal Reserve Bank of Kansas City ( email )

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Kansas City, MO 64198
United States

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