Limited-dependent rational expectations models with jumps

Abstract

This paper develops a Limited-Dependent Rational Expectations (LD-RE) model where the bounds can be fixed for an extended period, but are subject to occasional jumps. In this case, the behavior of the endogenous variable is affected by the agent's expectations about both the occurrence and the size of the jump. The RE solution for the one-sided and two-sided band are derived and shown to encompass the cases of perfectly predictable and stochastically varying bounds examined by earlier literature. We demonstrate that the solution for the one-sided band exists and is unique when the coefficient of the expectational variable is less than one. In the case of a two-sided band, the RE solution exists for all the parameter values and is unique if the coefficient of the expectational variable is less than or equal to one. These results hold even when the jump probability is stochastically varying and the error terms are conditionally heteroskedastic. As an illustration, we estimate a model of exchange rate determination in a target zone using data for the Franc/Mark exchange rate. Empirical results provide support for the non-linear model with time-varying realignment probability and indicate that the agents correctly anticipated most of the observed changes in the central parity.Rational expectations (Economic theory)