Working Paper: CEPR ID: DP513
Authors: Giuseppe Bertola; Lars E. O. Svensson
Abstract: In our model, an exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluations occur. We provide explicit solutions for the stochastic processes followed by the exchange rate and by the expected rate of depreciation when the likelihood and the size of devaluations vary stochastically over time. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, and provides interesting interpretations of available empirical evidence. We also specify a technique for inferrring the risk of devaluation from target-zone data.
Keywords: target zones; devaluations; exchange rates; interest rate differentials
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate position relative to target zone boundaries (F31) | expected rate of depreciation (E43) |
| perceived higher risk of devaluation (F31) | exchange rate weakness (F31) |
| variability of expected rate of devaluation (F31) | correlation between exchange rates and interest rate differentials (F31) |