Modelling the FF/MM rate by threshold cointegration analysis

This paper investigates a sticky-price model of exchange rate determination: extension of Krugman's target zone model with price inertia applied to the French Franc. A novel theoretical argument is considered, Threshold Cointegration, such that the long-run relationship between the parity and its fundamentals is dormant within a certain range of disequilibria but is restored when the system crosses the boundaries. Over the period 1987-1993, nonlinearities in the FF/DM rate, consistent with the credibility of this target zone, were detected by pointing out a band-reversion mechanism. A shock persistence analysis which highlights a nonlinear reversion of the exchange-rate deviation is also implemented.