- Stochastic process switching when the time is ripe
- Number of pages
- Amsterdam: Universiteit van Amsterdam
- Document type
- Working paper
- Faculty of Economics and Business (FEB)
- Amsterdam School of Economics Research Institute (ASE-RI)
Stochastic process switching typically links one mode (absorption or reflection) with one choice on
timing (state- or time-contingent). Sutherland (1995) combined absorption with both choices on
timing allowing the switch to take place at first hitting or at a given point of time, whichever date
comes first. We develop a different hybrid approach in which the two modes are combined with
state-contingent timing via a so-called elastic boundary where absorption and reflection enter with
some probability. This allows the decision maker to postpone absorption until the time is ripe.
We first analytically solve the model of Sutherland (1995) as its extant solution requires numerical
integration and then apply it to the South African return to gold in 1925. Subsequently, we argue
that the elastic-boundary framework in that period emerged in proposals of Keynes as well as
policies in, for instance, Australia, the Netherlands, Switzerland and Japan. The exchange rate
solution reveals a trade-o¤ between added flexibility for decision makers and increased volatility
when market's anticipations on the likelihood of postponement change.
- Working Paper, September 27, 2011
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