Working Paper: NBER ID: w3394
Authors: Lars E.O. Svensson
Abstract: 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.\nUnder 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.
Keywords: exchange rate regimes; target zones; interest rates; capital mobility
JEL Codes: F31; F32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic interest rates (E43) | Rate-of-return bands (G12) |
| Rate-of-return bands (G12) | Credibility of the exchange rate regime (F33) |
| Expected future exchange rates (F31) | Exchange rate band (F31) |
| Exchange rate band (F31) | Credibility of the exchange rate regime (F33) |