Working Paper: NBER ID: w3576
Authors: Giuseppe Bertola; Lars E.O. Svensson
Abstract: This paper proposes a tractable and realistic nonlinear model of exchange rate dynamics, and argues that its predictions are consistent with available empirical evidence on exchange rate and interest differential behavior in real-life target zones. In our model, the exchange rate fluctuates between given boundaries for random lengths of time and jumps discretely when devaluations occur. We allow for stochastic variability in the likelihood and size of devaluations, and we provide explicit solutions for the stochastic processes followed by the exchange rate and by the expected rate of depreciation. 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 how to infer devaluation risk from target zone data.
Keywords: exchange rates; target zones; devaluation risk; interest differentials
JEL Codes: E42; F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| devaluation risk (F31) | exchange rate behavior (F31) |
| exchange rate's position within fluctuation band (F31) | expected rate of depreciation (E43) |
| stochastic processes governing devaluation risks (F31) | expected rate of depreciation (E43) |
| expected rate of depreciation (E43) | interest rate differentials (E43) |
| target zone characteristics (R32) | perceived devaluation risks (F31) |