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I would like to acknowledge the comments and suggestions of Ricardo Caballero, Gustavo Canonero, Martina Copelman, Rudiger Dornbusch, Stanley Fischer, Luis Herrera and Peter Wickham. I also want to thank Gil Bufman and Leonardo Leiderman for providing the data. This research was partly supported by a grant from the World Economy Laboratory at MIT.
If we think in terms of a monetary model f will be the sum of the nominal money stock and a velocity shock. Starting with a money demand as follows m−p=v+y−απ, and assuming purchasing power parity, we can arrive at equation (1).
The model will not change if I alternatively assume that a realignment implies a jump of fixed size in the exchange rate independently of the position in the band, and that this level of the exchange rate will be the new central parity. Thus, the central parity is adjusted by different amounts depending on the position of the exchange rate inside the band. At the time of a realignment the money supply will be adjusted to achieve this result.
I will assume that these two stochastic processes are uncorrelated.
Although the model of the previous section did not include a deterministic trend for the devaluation of the central parity, this will not change any of the results. All the results in the paper will only shift by a constant.
The estimation of the expected change of the exchange rate inside the band is done under the assumption that no realignment takes place. Because of this reason in the case of Israel we drop the observations from the months before and after each realignment.
Several specifications were tried and the results presented here were not changed.
The estimation procedure does not incorporate the possibility that the expected future deviations of the exchange rate from the central parity cannot be greater than the width of the band. A logistic transformation that took this into account was tried and the results were similar to those reported here. Another drawback is the lack of offshore interest rates denominated in mexican pesos and new sheckels.
We rejected the null hypothesis of a unit root at 20 percent for the expected realignment and the interest rate differential for both countries.
Where a lower order process was appropriate we estimated that instead. These results are available upon request.