Exchange Rate Economics: Theories and Evidence

Speculative attack models and contagion 331
The estimated one step ahead probabilities increase quite sharply before each of
these devaluations,and decline sharply thereafter. Ninety-five per cent confidence
intervals are also constructed for the conditional expected exchange rates (forecasts)
and these show that for the 1976:Q3 devaluation the conditional expected
exchange rate falls within the confidence interval,but the 1981 devaluation
does not.
Cumby and Wijnbergen (1989) use a similar analysis and monthly data to analyse
the Argentine crawling peg,1979–80. Consistent with the basic model,they find
that a sharp increase in growth of domestic credit is the main factor triggering an
attack on the currency.
13.2.2 Empirical evidence on self-fulfilling crises and
escape clause models
A number of papers have used Markov–Switching-regime models in an attempt to
capture regime changes which are unrelated to fundamentals. For example,Jeanne
and Masson (2000) have proposed interpreting the regime shifts identified by
such models as jumps between multiple equilibria because the Markov–Switchingregime
model can be interpreted as a linear reduced form of a structural escape
clause model with sunspots. In particular,Jeanne and Masson (2000) estimate a
two-state Markov–Switching model for the French franc–German mark exchange
rate over the period 1979–86. They follow the second generation/escape clause
literature and include a broader range of fundamentals than in the first generation
models. In particular,the probability of devaluation was specified as:
π t = γ st + β u u t + β b tbal t + β r rer t + v t ,(13.42)
where u represents the unemployment rate,tbal is the trade balance as a ratio
of GDP,rer is percentage deviation of the real effective exchange rate from its
1990 level and the dependent variable is the 1 month interest differential between
euro-franc and euro-DM instruments,after correction for the expected movement
towards the centre of the band using the risk-adjusted method of Svensson (1993)
(see Chapter 12). The error term is assumed to be normally distributed with variance
σ 2 v . The constant term depends on two potential states (i.e. s t = 1or2)and
is the term which captures the potential multiple equilibria in this class of model.
Assuming this term is constant,estimates of the purely fundamental-based model
are recovered using OLS. Jeanne and Masson find that the coefficient estimates
recovered are often wrongly signed and the fitted value from this expression does
not do a good job of tracking the actual probability of devaluation,particularly
in periods associated with speculation. However,when the two-state model is
estimated,the fit of the model improves dramatically,all of the coefficients are
correctly signed and the actual and fitted probabilities track each other closely,
particularly around the periods of speculative pressure. Jeanne and Masson infer
from this that the Markov–Switching model provides a better fit for the probability