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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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25.2 The KFG Model

In the KFG model, the monetary authority fixes the exchange rate initially by offering to buy or sell international reserves at the fixed exchange rate. In the background is some set of higher-priority polices that make the fixed rate unsustainable. Since government's commitment to the exchange rate is limited and at odds with the higher-priority policies, the fixed rate will eventually be abandoned in a currency crisis. The KFG model is about determining the probability distribution for the timing of the crisis.

Fixing the exchange rate is a monetary policy, so the model is organized around the money market:

25.1 25.1

where time is measured discretely, images is the log of high powered money at time t, images is the log domestic price level, images is the domestic interest rate, images is the log domestic output, images is a money-demand shock, and α > 0, γ > 0, and are fixed parameters.

Uncovered interest ...

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