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Estimating Credibility in Colombia's Exchange Rate Target Zone

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  • Arturo José Galindo

Abstract

This paper analyzes credibility in the Colombian exchange rate target zone. A model of imperfect credibility, in the spirit of Bertola and Svensson (1993) is derived, and is used to explain why the exchange rate in Colombia has remained for prolonged periods near the borders of the zone. The main feature of the model is that central parity depreciation expectations are endogenous with respect to the position of the exchange rate inside the target zone. The krugman(1991) perfectly credible setup turns out to be a particular case of this general model. One of the main implications of the model is that depreciation expectations increase rather than decrease as the exchange rate approaches the upper band. Hence a model as the one presented in this paper, is useful to explain the recent dynamics of interest rates in Colombia. It is also shown, that this model shares empirical features with the basic target zone model. Hence, policy makers might be misled when trying to recognize their credibility stance. A estructural estimation of the underlying parameters of the model, using McFadden's (1989) method of simulated moments, is suggested to identify the presence of non credibility issues. Econometric evidence suggest that Colombia's exchange rate target zone is properly described by a model of this nature.

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Paper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 103.

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Handle: RePEc:bdr:borrec:103

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  1. Bekaert, G.R.J. & Gray, S.F., 1997. "Target zones and exchange rates: An empirical investigation," Discussion Paper 1997-22, Tilburg University, Center for Economic Research.
  2. Whitney K. Newey & Kenneth D. West, 1986. "A Simple, Positive Semi-Definite, Heteroskedasticity and AutocorrelationConsistent Covariance Matrix," NBER Technical Working Papers 0055, National Bureau of Economic Research, Inc.
  3. Rose, Andrew K & Svensson, Lars E O, 1991. "Expected and Predicted Realignments: The FF/DM Exchange Rate During the EMS," CEPR Discussion Papers 552, C.E.P.R. Discussion Papers.
  4. Cukierman, Alex & Spiegel, Yossi & Leiderman, Leonardo, 2004. "The choice of exchange rate bands: balancing credibility and flexibility," Journal of International Economics, Elsevier, vol. 62(2), pages 379-408, March.
  5. Lindberg, Hans & Soderlind, Paul, 1994. " Intervention Policy and Mean Reversion in Exchange Rate Target Zones: The Swedish Case," Scandinavian Journal of Economics, Wiley Blackwell, vol. 96(4), pages 499-513.
  6. Donald J. Mathieson & Robert P. Flood & Andrew K. Rose, 1991. "An Empirical Exploration of Exchange Rate Target-Zones," IMF Working Papers 91/15, International Monetary Fund.
  7. Bertola, G. & Svensson, L.E., 1990. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," Papers 481, Stockholm - International Economic Studies.
  8. Svensson, L.E.O., 1989. "Target Zones And Interest Rate Variability," Papers 457, Stockholm - International Economic Studies.
  9. Peter M. Garber & Lars E.O. Svensson, 1994. "The Operation and Collapse of Fixed Exchange Rate Regimes," NBER Working Papers 4971, National Bureau of Economic Research, Inc.
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  12. de Jong, F, 1994. "A Univariate Analysis of EMS Exchange Rates Using a Target Zone Model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 9(1), pages 31-45, Jan.-Marc.
  13. Richard Meese & Kenneth Rogoff & Jacob Frenkel, . "The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?," Working Paper 32044, Harvard University OpenScholar.
  14. Raúl A. Feliz & John H. Welch, 1994. "Un análisis de la credibilidad y del comportamiento de las bandas unilaterales de los tipos de cambio en México y Chile," Economia Mexicana NUEVA EPOCA, , vol. 0(1), pages 5-30, January-J.
  15. Lee, Bong-Soo & Ingram, Beth Fisher, 1991. "Simulation estimation of time-series models," Journal of Econometrics, Elsevier, vol. 47(2-3), pages 197-205, February.
  16. Lindberg, H. & Soderlind, P., 1991. "Testing the Basic Target Zone Model on Swedish Data," Papers 488, Stockholm - International Economic Studies.
  17. Jong, F.C.J.M. de, 1994. "A univariate analysis of EMS exchange rates using a target zone model," Open Access publications from Tilburg University urn:nbn:nl:ui:12-384515, Tilburg University.
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Cited by:
  1. Galindo, Arturo Jose, 2001. "The credibility of the Colombian exchange rate target zone: Its impact over the volatility of interest rate differentials," The Quarterly Review of Economics and Finance, Elsevier, vol. 41(1), pages 111-118.

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