Regime switching behavior of the nominal exchange rate in Uganda

Abstract

PurposeThis paper aims to examine regime switching behaviour of the nominal exchange rate in Uganda to shed light on the necessity (as well as efficacy) of the participation of the central bank market.Design/methodology/approachThe homogenous two‐state Markov chain methodology was employed to investigate the possibility of regime changes in the nominal exchange rate. The maximum likelihood parameter estimates were obtained using the Broyden‐Fletcher‐Goldfarb‐Shanno iteration algorithm.FindingsThe results validate the expectation of the two distinct state spaces characterized as sharp and disruptive but short‐lived depreciations as well as small appreciations occurring through a long period. The central bank intervention actions are shown to be largely successful in mitigating the disruptive effects of the sharp depreciations.Practical implicationsThe paper lends empirical support to the intervention actions of the Bank of Uganda. In face of the numerous disruptions to the short‐term exchange rate process, failure to intervene may cause rational panic and given the nature of investor behavior, this may quickly spread and even cause further disruptions. It is important for the central bank to send signals that these disruptions are temporary.Originality/valueThe homogenous Markov chain specification employed in this study makes it possible to avoid the pitfalls that may arise by attempting to specify a structural model for the exchange rate. In addition, inference about the different possible state spaces is made on the basis of all available information.