Exchange Rate Target Zone Research Articles

Exchange Rate Target Zone Models: A Bayesian Evaluation

This paper develops a Bayesian approach to estimating exchange rate target zone models and rational expectations models in general. It also introduces a simultaneous-equation target zone model that incorporates stochastic realignment risk. Using FF/DM and IL/DM exchange rate data, we find that the signing of the 1987 Basle-Nyborg Agreement reduces both the magnitude and the likelihood of a central parity realignment, while the lagged exchange rate deviation from its central parity increases them. Furthermore, the interest rate policies and the monetary conditions of the participating countries signal a forthcoming realignment. In general, we are unable to improve upon a simple random walk model in out-of-sample exchange rate prediction by introducing target zone models.

On the mean-reverting properties of target zone exchange rates: Some evidence from the ERM

One key prediction of the target zone model is that the exchange rate should be mean-reverting within the band. Although this property is widely referred to in the target zone literature, little work has been done to test it. In this paper we seek to remedy this important lacuna in the literature by examining the time-series properties of the seven currencies participating in the Exchange Rate Mechanism (ERM) of the European Monetary System, for the period 13 March 1979 to 9 April 1992. Using standard univariate unit root tests we find little evidence of mean reversion. However, using variance ratio test statistics, which control for heterogeneity in the distribution of exchange rate behaviour, we find much more evidence of mean reversion. Another part of our work includes implementing a panel unit-root test.

ERM Realignment Risk and its Economic Determinants as Reflected in Cross‐rate Options

This paper uses data on over-the-counter options between the mark and the pound, lira, French franc, and peseta to investigate the credibility of exchange rate target zones within the ERM. We compare empirical implications for the relation between option prices and the spot's position within the band for three classes of target zone models: those with full credibility, those with exogenous realignment risk, and those with endogenous realignment risk. Empirically, implied volatility from these options attains a maximum near the edges of an exchange rate band rather than its centre, even three to six months prior to realignment.

Target Zone Models with Price Inertia: Extended Numerical Solutions

For examining the logic of exchange rate regimes a more political based approach is analyzed in a macroeconomic framework. This paper tries to outline the impact of additional defended economic targets on an explicitly announced nominal exchange rate target zone regime. The stochastic exchange rate model used yields an ordinary differential equation (ODE) with interval limits as unknown parameters. By adopting linear and nonlinear target zone restrictions on the foreign exchange market, the ODE has to be solved subject to these restrictions. This problem is solved numerically by a special method which merges the ODE solution process with the parameter identification.

The scope for monetary independence in exchange rate target zones broad and narrow

Placing limits on the movement of economic fundamentals in order to maintain an exchange rate within a target zone also puts a target zone around interest rate differentials. The bandwidth of exchange rate and interest rate differentials target zones will be different except at one point; it is suggested that this point gives a useful partitioning of target zones into broad and narrow categories. For realistic parameter values, this occurs at an exchange rate target zone of plus or minus 3.2%.

An analytical approximation of target zone exchange rate functions: the technique of collocation

This paper applies the analytical approximation technique of collocation to the stochastic sticky-price exchange rate target zone model. The technique can be used to trace out the resulting nonlinear exchange rate path with remarkable accuracy while requiring comparatively little computational effort.

Estimating the credibility of an exchange rate target zone

Recent breakthroughs in the theory of exchange rate target zones have not been followed by similar contributions on the empirical side. The drift adjustment method of evaluating the credibility of a target zone has become common practice. However, the estimates of the expected rate of depreciation inside the band do not model knowledge of the band in the agents' information set. In this paper, a rational expectations limited-dependent variable method to estimate the expected rate of depreciation is used to remedy this weakness. In the case of the franc-mark target zone with daily data covering a 4-year period, we show that expected rates of devaluation of the order of 2.5% were still present in the early 1990s. Their reappearance in the autumn of 1992 may thus not be surprising.

Dynamic Inconsistency and Exchange-Rate Target Zones: A Welfare Analysis

This paper examines the welfare implications of different exchange-rate systems, especially an exchange-rate target-zone system, in a context of monetary policy making and dynamic inconsistency. It is shown that when there is uncertainty, there is a trade-off between commitment to a rule and discretion. A free-floating exchange-rate system may have the same loss function values in terms of price and output fluctuations as that of a target zone. However, a target-zone system may be more attractive since there is less exchange-rate fluctuation. Returning to a fixed-rate system may be worse since it may bring about larger welfare losses especially when supply shocks dominate. [F31, E52]

Exchange rates under EMS target zones: an econometric investigation

This study tests Krugman's model on exchange rate target zones using four old EMS exchange rates (those of the currencies of Belgium, France, Italy and the Netherlands against the Deutsche mark). Vast theoretical literature is available but there are very few empirical studies testing the main results of Krugman's model, namely the ‘honeymoon effect’, ‘smooth pasting’ and the overall S-curved relationship between fundamental and exchange rate. The present study supports the honeymoon effect but does not find any evidence in support of ‘smooth pasting’ or of an S-curved relationship between the exchange rate and fundamentals for the Belgian franc, French franc and Italian lira against the Deutsche mark. The Dutch guilder very closely follows movements in the German mark throughout the period 1981—90. End-of-month exchange rates and Euro-currency interest rates data are used.

Persistent exchange-rate misalignment, noneconomic fundamentals and exchange-rate target zones

This paper examines the role of an exchange-rate target zone system in the presence of a persistent exchange-rate misalignment caused by noneconomic fundamentals such as “fads,” as compared to fixed rate and free floating systems. Output variations in each of the regimes and the relationship between the band width and variance of the shocks are also investigated.

Fundamentals and devaluation expectations in target zones: Some new evidence from the ERM

The credibility of exchange rate target zones for four EMS countries for the period March 1979-September 1992 is examined. Existing methods by Svensson, Edin and Vredin, typically applied to data from the Nordic countries, are considered. On balance, the method suggested by Edin and Vredin provides somewhat better estimates of devaluation probabilities than either of Svensson's methods. While all methods produce reasonably good estimates of the expected size of devaluations, they did not predict the September 1992 EMS crisis. However, we find that electoral and other institutional variables improve estimates of devaluation expectations.

Exchange rate target zones, realignments and the interest rate differential: Theory and evidence

This paper develops a target zone model for the exchange rate where the expected realignment is an increasing function of the distance of the exchange rate from the central parity, as a percentage of the width of the band. In this framework, the interest rate differential increases with the deviation of the exchange rate from the central parity when the exchange rate is close to the central parity, and it decreases when the exchange rate is close to the edges of the band. Finally, the paper looks at the evidence from the EMS, and finds partial support for the implications of the model.

A statistical identity linking folded and censored distributions

This paper models expected future values of Gaussian stochastic processes that are bounded by reflecting barriers. Such expectations are of course crucial to any model with forward looking agents. The approach is illustrated by applying it to an exchange rate target zone. By adopting a distributional approach, the formal analysis can be both simple and somewhat elegant. In doing so, we show that the first moments of folded and censored distributions are related in a surprisingly neat way. The setting is discrete-time, though where appropriate we extend the analysis to the continuous-time analogue of reflected Brownian motion.

Monetary and real shocks and the optimal target zone

An exchange rate target zone is analysed in a model where the economy is disturbed by shocks to money demand and goods demand. The stabilising properties of a target zone are compared to those of fixed and flexible exchange rate regimes. It is found that a target zone offers a compromise between these two extremes. It is also shown that, when there are shocks to both money and goods demand, a target zone is better than either a fixed rate or a floating rate in the sense that it minimises the variance of output and prices.

Intervention Policy and Mean Reversion in Exchange Rate Target Zones: The Swedish Case

The intervention policy of the Swedish central bank is studied using daily intervention data for the late 1 980s. In contrast to the first generation of target zone models, we find that the interventions occur all over the exchange rate band and almost every day. Based on this evidence, we estimate an exchange rate target zone model with intra-marginal interventions. The results go a long way towards explaining the well-established hump-shaped exchange rate distribution and lack of non-linearities.

Target zone modelling and estimation for European Monetary System exchange rates

Krugman (1991) provided a rigorous economic argument for the merits of target zone exchange rate arrangements. His analysis revealed the existence of a stabilizing nonlinear relation between the exchange rate and its driving fundamentals. However, the econometric testing of this relationship has proved difficult. We use data from the European Monetary System (EMS) to implement efficient testing of the Krugman model and extensions which allow mean reversion in the fundamentals process. In particular, we model the fundamentals driving the bilateral exchange rates of participating currencies by means of an Ornstein Uhlenbeck process with reflecting barriers. This specification captures the enforcement of an exchange rate fluctuation band through central bank intervention at band limits as well as through intramarginal intervention. Our empirical work is based on a period of exceptional stability in exchange rate markets and well approximates the credible band limit assumptions common in the target zone modelling literature. Building on recent work by Ricciardi and Sacerdote (1987), de Jong (1991), and Lindberg and Söderlind (1991, 1992), we implement full maximum likelihood estimation of the parameters of the time series dynamics for the most heavily traded bilateral exchange rates in the EMS. In doing so we identify the functional relation between the fundamentals and the exchange rate and quantify the nonlinearity in this relation. When nonlinearity is not present, a restriction of the model posits that the exchange rate, per se, follows a reflected OU process. A further restriction contains reflected Brownian motion as a nested special case. Our analysis affords a description of the alternative exchange rate policies adopted in the various countries party to the EMS.

How long do unilateral target zones last?

We examine the expected survival time of a unilateral exchange rate target zone, when constraints on monetary policy prevent the central bank from exclusively focusing on defending the target zone. Generally the width of the target zone has a negligible effect on the expected survival time, and the dominant determinants are reserve levels and the degree of real and monetary divergence between the country in question and the rest of the world. For seemingly realistic parameters, the expected survival time is fairly long: a few decades rather than a few years.

Realignments of Target Zone Exchange Rate Systems: What Do We Know?

Realignments of Target Zone Exchange Rate Systems: What Do We Know?

Exchange Rate Target Zones in a Utility Maximizing Framework

We present a monetary model of unilateral exchange rate target zone based on microeconomic optimization principles. We endogenously derive the consumer's consumption and protfolio choices, and the demand for money balances. The standard monetary model results, like the S-shaped solution for the exchange rate and the transfer of volatility from exchange rates to nominal interest rates are also obtained.

An Interpretation of Recent Research on Exchange Rate Target Zones

How do exchange rate bands work compared to completely fixed rates (between realignments); or, more precisely, what are the dynamics of exchange rates, interest rates, and central bank interventions within exchange rate bands? Does the difference between bands and completely fixed exchange rates matter, and if so, which of the two arrangements is best; or, more precisely, what are the tradeoffs that determine the optimal bandwidth? This article will present an interpretation of some selected recent theoretical and empirical research on exchange rate target zones, with emphasis on main ideas and results and without technical detail.