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Estimation of Nonlinear Exchange Rate Dynamics in Evolving Regimes

CID Faculty Working Paper No. 429

Jeffrey Frankel, Yao Hou, and Danxia Xie 
March 2023


This paper develops a new econometric framework to estimate and classify exchange rate regimes. They are classified into four distinct categories: fixed exchange rates, BBC (band, basket and crawl), managed floating, and freely floating. The procedure captures the patterns of exchange rate dynamics and the interventions by authorities under each of the regimes. We pay particular attention to the BBC and offer a new approach to parameter estimation by utilizing a three-regime Threshold Auto Regressive (TAR) model to reveal the nonlinear nature of exchange rate dynamics. We further extend our benchmark framework to allow the evolution of exchange rate regimes over time by adopting the minimum description length (MDL) principle, to overcome the challenge of simultaneous two-dimensional inference of nonlinearity in the state dimension and structural breaks in the time dimension. We apply our framework to 26 countries. The results suggest that exchange rate dynamics under different regimes are well captured by our new framework.

Keywords: Exchange rate regime, MDL, Minimum Description Length, structural breaks, TAR, Threshold Autoregression

JEL Classification: F33