Spurious Correlation in Exchange Rate Target Zone Modelling: Testing the Drift Adjustment Method on the U.S. Dollar, Random Walk and Chaos

CEPR Discussion Paper Series No. 1890

Posted: 12 Nov 1998

See all articles by Zsolt Darvas

Zsolt Darvas

Budapest University of Economic Sciences and Public Administration

Date Written: May 1998

Abstract

The drift-adjustment method estimates the expected rate of depreciation within an exchange rate band by simple equations. Papers applying this method claim that, while forecasting a freely floating currency is hopeless, predicting an exchange rate within the future band is successful. This paper shows that the results achieved by applications to EMS and Nordic currencies are not specific to data of target zone currencies. For example, application to U.S. dollar leads qualitatively to the same result as application to EMS currencies. Simulation evidence suggests that the closer the dominant inverted autoregressive root to unity the higher the chance of reproducing the empirical target zone results, since the finite sample biases of the parameters of interest in the unit root case are such that the random walk seemingly significantly fits the model in the vast majority of experiments. HAC standard errors do not help much in hypothesis testing either. The paper develops a simple model coinciding with stylized facts of target zones that demonstrates the unpredictability of the expected rate of depreciation within the band. Surprisingly, application of drift-adjustment method to a process switching between stationary periods and chaotic periods, the fit is similar to reported target zone results.

JEL Classification: C22, F31

Suggested Citation

Darvas, Zsolt, Spurious Correlation in Exchange Rate Target Zone Modelling: Testing the Drift Adjustment Method on the U.S. Dollar, Random Walk and Chaos (May 1998). CEPR Discussion Paper Series No. 1890, Available at SSRN: https://ssrn.com/abstract=125488

Zsolt Darvas (Contact Author)

Budapest University of Economic Sciences and Public Administration ( email )

Budapest H-1093
Hungary

HOME PAGE: http://www.uni-corvinus.hu/darvas

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