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The Simplest Test of Target Zone Credibility

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  • 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. Under 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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3394.

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Date of creation: Jun 1990
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Publication status: published as International Monetary Fund Staff Papers, Vol. 38, No. 3, pp. 655-665, (September 1991).
Handle: RePEc:nbr:nberwo:3394

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  1. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  2. Svensson, L.E.O., 1990. "The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data," Papers 466, Stockholm - International Economic Studies.
  3. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August.
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