Exchange Rate Target Zone Research Articles

The foreign exchange risk premium in a target zone with devaluation risk

The foreign exchange risk premium in an exchange rate target zone is derived, when the exchange rate is heteroskedastic within the band and there is a separate devaluation risk. The risk premium is then the sum of two separate risk premia, arising from uncertainty about exchange rate movements within the band and from uncertainty about devaluations. Both real and nominal risk premia are considered. Real and nominal risk premia from movements within the band are very small. Real and nominal risk premia from devaluations are larger but still relatively small proportions of the interest rate differential.

Target zones and international policy coordination: The contrast between the necessary and sufficient conditions for success

This paper distinguishes between the necessary and sufficient conditions for adopting exchange rate target zones for improving macroeconomic performance. The necessary conditions are easily satisfied, but it is much more difficult to design a targetting system which satisfies the sufficient conditions when the exchange rate is an intermediate target. On that criterion the gains may be smaller than previously estimated. However, target zones have important practical advantage. They are effective in promoting stability, and as a simple but uncontroversial way of securing the coordination necessary to prevent policy makers adopting inefficient or competitive policies.

Target Zones and Forward Rates in a Model with Repeated Realignments

This paper studies the implications of the imperfect credibility of an exchange rate target zone on the term structure of forward premia. The relationship between spot and forward exchange rates of different maturities reflects the possibility of repeated realignments of the exchange rate band. The credibility of the commitment to the target zone implicit in forward market data can be extracted by estimating the model. Application to French/German data indicates that the model is capable of matching observed patterns of interest rate differentials during the EMS, while yielding estimates of the credibility parameters that accord with the experience of the FF/DM exchange rate during the 1980s.

Target Zones and Forward Rates in a Model with Repeated Realignments

This paper studies the implications of the imperfect credibility of an exchange rate target zone on the terra structure of forward premia. The relationship between spot and forward exchange rates of different maturities reflects the possibility of repeated realignments of the exchange rate band. The credibility of the commitment to the target zone implicit in forward market data can be extracted by estimating the model. Application to French/German data indicates that the model is capable of matching observed patterns of interest rate differentials during the EMS, while yielding estimates of the credibility parameters that accord with the experience of the FF/DM exchange rate during the 1980s.

THE EUROPEAN MONETARY SYSTEM: CREDIBLE AT LAST?

We update tests of the credibility of the EMS exchange rate target zones. Our main methodological innovation is to use a survey of exchange rate forecasts, as well as interest differentials, in measuring exchange rate expectations. We investigate the hypothesis -- suggested by the apparent stabilization of the EMS and by recent institutional developments -- that the EMS target zones have experienced an increase in credibility since their 1987 realignment. The evidence tends to support this hypothesis for most currencies. We also examine the empirical failure of standard target zone models, but find no evidence that it can be attributed to mismeasurement of expectations. Finally, we consider an alternative credibility measure which captures the importance of possible realignments in overall expectations of exchange rate changes.

The International Adjustment Process: New Perspectives, Recent Experience and Future Challenges for the Financial System

A Opening Addresses.- I Introduction.- II The Role of Financial Markets in the Adjustment Process: the Finnish Experience.- III The International Adjustment Process.- IV Problems of Adjustment in Developing Countries.- B Current and Potential Balance of Payments Adjustment Problems.- V External Adjustment in Small Open Economies - Some Recent Experience.- VI Balance of Payments Adjustment Processes in Japan.- VII US External Adjustment in Response to the Lower Dollar: the J-Curve.- VIII Balance of Payments Adjustment Problems - the Case of West Germany.- C The Modus Operandi of The Process of Adjustment.- IX Current and Prospective Balance of Payments Problems.- X Policy Design in the Face of a Terms of Trade Shock.- XI Financial Interdependence and External Adjustment: Some Problems Posed by US Federal Government Indebtedness.- XII Mode Operatoire D'ajustement et Marches Speculatifs - Premiers Enseignements de la Crise Financiere Recente.- D Adjustment Policies.- XIII Exchange Rate Target Zones, the Louvre Accord and Policy Coordination.- XIV Reflections on World Economic Imbalances.- XV The International Economic Adjustment Mechanisms and the Coordination of Economic Policies.- XVI Recent Experience of International Monetary Policy Cooperation.- XVII The International Monetary System: Recent Developments and Key Issues.- E Special Problems of Adjustment in Developing Countries.- XVIII Special Problems of Adjustment in Developing Countries.- XIX Private Capital Flows and Developing Country Adjustment: Some Lessons of the Debt Crisis.- XX The Exchange Rate in the Adjustment Process of Less Developed Countries - a Multifarious Role.- XXI Foreign Lending Revisited 1880-1980.- F Concluding Address.- XXII Issues in International Economic Management.

The Simplest Test of Target Zone Credibility

Under the assumption of no arbitrage, the credibility of an exchange rate target zone is tested by whether domestic interest rates fall within rate-of-return bands between the maximum and minimum home currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. These tests are applied on data on the Swedish target zone from January 1987 through August 1990.

The term structure of interest rate differentials in a target zone: Theory and Swedish data

The term structure of interest rate differentials is derived in a model of a small open economy with a target zone exchange rate regime. For given time to maturity the interest rate differential is decreasing in the exchange rate, and for given exchange rate the interest rate differential's absolute value and its instantaneous variability are both decreasing in the time to maturity. Devaluation/realignment risks are incorporated and imply upward shifts of the interest rate differentials. Several implications of the theory are found to be broadly consistent with data on Swedish exchange rates and interest differentials for the period 1986–1989.

Expected and Predicted Realignments: The FF/DM Exchange Rate during the EMS, 1979-93

An empirical model of time-varying realignment risk in an exchange rate target zone is developed. Expected rates of devaluation are estimated as the difference between interest race differentials and estimated expected rates of depreciation within the exchange rate band, using French Franc/Deutsche Mark data during the European Monetary System. The behavior of estimated expected rates of depreciation accord well with the theoretical model of Bertola-Svensson (1990) . We are also able to predict actual realignments with some success.

Expected and Predicted Realignments: The FF/DM Exchange Rated During the EMS

An empirical model of time-varying realignment risk in an exchange rate target zone is developed. Expected rates of devaluation are estimated as the difference between interest rate differentials and estimated expected rates of depreciation within the exchange rate band, using French Franc/Deutsche Mark data during the European Monetary System. The behavior of estimated expected rates of depreciation accord well with the theoretical model of Bertola-Svensson (1990). We are also able to predict actual realignments with some success.

Target zone exchange rate

This paper attempts to rationalize the target zone exchange rate system's width proposed by Williamson (1983). The model is a special case of the Exponentially Weighted Moving Average (EWMA) function. Given the time series distribution, estimated means and variances are plotted on a bounded (upper and lower) standard normal distribution.

Is the EMS the Perfect Fix? An Empirical Exploration of Exchange Rate Target Zones

In the context of a flexible-price monetary exchange rate model and the assumption of uncovered interest parity, we obtain a measure of the fundamental determinant of exchange rates. Daily data for the European Monetary System is then used to explore the importance of non-linearities in the relationship between the exchange rates and fundamentals. While some statistical evidence of non-linearities in conditional means of exchange rates is detected, these seem to have little economic content. A number of implications of existing "target zone" exchange rate models are tested; little support is found for existing models of limited exchange rate flexibility.

Target Zones and Interest Rate Variability

The trade-off between interest rate variability and the width of an exchange rate target zone is examined, using the regulated Brownian motion model of target zones. The interest rate differential’s asymptotic (unconditional) variability is increasing in the exchange rate band for narrow bands; whereas it is slowly decreasing for wide bands. The interest rate differential’s instantaneous (conditional) variability is decreasing in the exchange rate band. The model is extended to include a realignment/devaluation risk, as well as an endogenous exchange rate risk premium. The risk premium is small for reasonable parameter values.

The Simplest Test of Target Zone Credibility

A credible target zone exchange rate regime with a given exchange rate band implies bounds on the amount of depreciation and appreciation of the domestic currency. This implies, for given foreign interest rates, bounds on the domestic-currency rate of return on foreign investment: a rate-of-return band for each time to maturity. Whether domestic interest rates are outside these rate-of-return bands can be used as a simple test of exchange rate credibility, under the assumption of sufficient international capital mobility. This test is applied to the Swedish target zone during February 1986-February 1990.Under the additional assumption of uncovered interest rate parity, an equivalent test is whether expected future exchange rates are outside the exchange rate band. In addition, the expected future exchange rates are used to give an estimate of the probability of future devaluations.

The Linkage between Speculative Attack and Target Zone Models of Exchange Rates

In this paper we generalize the target zone exchange rate as model formalized by Krugman (1988b) to include finite-sized interventions in defense of the zone. The main contributions of these pages consist of linking the recent developments in the theory of target zones to the mirror-image theory of speculative attacks on asset price fixing regimes and in using aspects of that linkage to give an intuitive interpretation to the smooth pasting condition usually invoked as a terminal condition.

Exchange rate flexibility, target zones, and policy coordination

At its meeting in April 1986, the Interim Committee asked the [Fund's] Executive Board to consider further whether there are any modifications in the exchange rate that could contribute to enhancing exchange rate stability and the mutual consistency of economic policies without sacrificing the essential flexibility of the system (Interim Committee, 1986, para 5). This was interpreted by a part of the press as an official rejection of target zones, which was odd inasmuch as the target zone proposal can be regarded as a technique to limit misalignments and enhance policy consistency while retaining the very real benefits that exchange rate flexibility can bring. The present paper seeks to explain why I regard this intermediate regime between fixed and floating exchange rates as offering the most attractive combination of the features of the two systems. Section 2 of the paper explains briefly what I understand by the target zone proposal. Section 3 explains how the four dimensions of flexibility built into the proposal could satisfy all the real social functions that floating can further. Section 4 argues that the proposal could also help both to limit misalignments and to secure policy consistency. Section 5 explores the relation of the target zone approach to proposals for objective indicators.

The Gold Standard in Theory and History.

Since the successful first edition of The Gold Standard in Theory and History was published in 1985, much new research has been completed. This updated version contains five new essays including: * post 1990 literature on exchange rate target zones * a discussion of the light shed by the gold standard on the European Monetary Union debate * a new introduction by Eichengreen with Marc Flandreau This will be an invaluable resource for students of macroeconomics, international economics and economic history at all levels.