A regime-switching approach to the study of speculative attacks: A focus on EMS crises

Abstract

This paper implements a regime-switching framework to study speculative attacks against EMS currencies during 1979–1993. To identify speculative episodes, we model exchange rates, reserves, and interest rates as time series subject to discrete regime shifts between two possible states: “tranquil” and “speculative”. We allow the probabilities of switching between states to be a function of fundamentals and expectations. The regime-switching framework improves the ability to identify speculative attacks vis-à-vis the indices of speculative pressure used in the literature. The results also indicate that fundamentals (particularly budget deficits) and expectations drive the probability of switching to a speculative state.

I am indebted to Barry Eichengreen, Richard Lyons, Maurice Obstfeld, and James Powell for their advice and encouragement. I greatly benefited from comments from the editors of this issue, James Hamilton and Baldev Raj, and from suggestions from two anonymous referees. I would also like to thank David Bowman, Jon Faust, Michael Gibson, Clive Granger, Dale Henderson, Chang-Tai Hsieh, Steve Kamin, Andy Levin, Gian Maria Milesi-Ferreti, John Rogers, Tom Rothenberg, Paul Ruud, and Sergio Schmukler for very helpful comments. Furthermore, I received fruitful suggestions from seminar participants at related presentations at the Central Bank of Argentina, Dartmouth College, Duke University, the Federal Reserve Bank of Boston, the Federal Reserve Board, the Inter-American Development Bank, Tufts University, Universidad San Andres, Wellesley College, Wesleyan University, and the World Bank Research Department. Finally, I would like to express my gratitude to Matthew Jones and Gretchen Weinbach for their help with the empirical estimations of the EM algorithm.