Working Paper: CEPR ID: DP580
Authors: Lars E. O. Svensson
Abstract: The paper presents estimates of devaluation expectations for six EMS currencies relative to the Deutschmark, for the period March 1979 - May 1990. The estimation method is simple and operational, and consistently generates sensible results. The estimates are constructed by adjusting interest rate differentials by subtracting estimated expected rates of depreciation within the exchange rate band. The adjustment is non-trivial because exchange rates within ERM bands display mean reversion rather than random walk (unit root) behaviour. The adjustment is essential since expected rates of depreciation within the band are usually of about the same magnitude as interest rate differentials.
Keywords: Exchange rate; Target zone; Realignment; Devaluation; European Monetary System; Unit root; Mean reversion
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| naive use of interest rate differentials (E43) | misleading conclusions about market expectations of realignment (D84) |
| interest rate differential (E43) | expected rate of devaluation (F31) |
| adjustment for expected rates of depreciation (E43) | estimation accuracy of devaluation expectations (F31) |