If the markka floated : simulating the BOF4 model with fixed and floating exchange rates

In this paper the BOF4 model of the Bank of Finland, which is estimated in a fixed exchange rate regime, is transformed into a model with a floating exchange rate. In endogenizing the exchange rate two alternative assumptions about the formation of exchange rate expectations are used, i.e. static and market- specific (MS) rational expectations. We found that under static expectations the adjustment paths of the exchange rate were very volatile when shocks originated from the financial market. In response to real shocks, however, the results were not sensitive with respect to the alternative expectations formation schemes. In the case of MS-rational expectations the reactions of the exchange rate to real and financial shocks were, also somewhat greater than typically presented in the literature. In addition, the response paths were highly cyclical.