Testing Target Zone Credibility with a Limited Dependent Variable Rational Expectations Model

Abstract

This essay applies a limited dependent variable rational expectations model to estimate the French Franc/Deutsche Mark (FF/DM) exchange rate in order to test the credibility of the European Exchange Rate Mechanism (ERM) for these currencies. The existing literature treats the exchange rate within the band as an unbounded con-tinuous 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 a limited dependent variable framework. My results indicate that accounting for the band in the drift adjustmen