Stochastic Process Switching and Intervention in Exchange Rate Target Zones: Empirical Evidence from the EMS

Exchange rate target zone models postulate that `in the absence of intervention' exchange rates are driven by their fundamentals, which in this case are assumed to follow an unregulated Brownian motion process-the continuous time equivalent of a random walk (with drift). Such random walk behaviour of freely floating exchange rates is a well-documented stylized fact. The possibility of policy intervention in foreign exchange markets, however, may lead to stochastic process switching: in a perfectly credible target zone the commitment of policy-makers to intervene at the boundaries of a band for the fundamentals gives rise to speculative bubbles, which stabilize the exchange rate within a narrower band. Inframarginal intervention may add to these stabilizing effects. On the other hand, in target zones which are imperfectly credible, policy intervention may also take the form of a realignment, a permanent jump in the central parity. The present paper employs a Bayesian approach to estimate the relative probabilities of these forms of stochastic process switching by using daily data on the Deutschmark exchange rate for the EMS currencies. The analysis reveals that for these EMS target zones intervention and realignment probabilities have recently declined drastically, and that the ERM is now close to being a fully credible peg.