State-space estimation of rational bubbles in the Yen/Deutsche Mark exchange rate

State-Space Estimation of Rational Bubbles in the Yen/Deutsche Mark Exchange Rate. — This paper considers a series that uncovered interest parity predicts to be white noise and inspects it for evidence of stochastic rational bubbles. State-space methods are used that specify a bubble component of the series as an unobserved state. The technique’s effectiveness is demonstrated by Monte Carlo experiments. One span of the series is found in which a stochastic rational bubble specification clearly dominates the white noise specification. It coincides with a period of general financial turm-oil in the associated economies, i.e. Japan and Germany during 1989 and early 1990.