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Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3576.

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Date of creation: Jan 1991
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Publication status: published as Review of Economic Studies, vol. 60, no. 3, July 1993 pp. 689-712,
Handle: RePEc:nbr:nberwo:3576

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  1. Delgado, F. & Dumas, B., 1990. "Monetary Contracting Between Central Banks And The Design Of Sustainable Exchange-Rate Zones," Weiss Center Working Papers 20-90, Wharton School - Weiss Center for International Financial Research.
  2. Shula Pessach & Assaf Razin, 1994. "Targeting the Exchange Rate: An Empirical Investigation," NBER Working Papers 3662, National Bureau of Economic Research, Inc.
  3. Francisco Delgado & Bernard Dumas, . "Monetary Contracting between Central Banks and the Design of Sustainable Exchange-Rate Zones (Reprint 035)," Rodney L. White Center for Financial Research Working Papers 20-90, Wharton School Rodney L. White Center for Financial Research.
  4. Miller, Marcus & Weller, Paul, 1989. "Exchange Rate Bands and Realignments in a Stationary Stochastic Setting," CEPR Discussion Papers 299, C.E.P.R. Discussion Papers.
  5. Froot, Kenneth & Obstfeld, Maurice, 1991. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," CEPR Discussion Papers 522, C.E.P.R. Discussion Papers.
  6. Delgado, F. & Dumas, B., 1990. "Monetary Contracting Between Central Banks And The Design Of Sustainable Exchange-Rate Zones," The Warwick Economics Research Paper Series (TWERPS) 360, University of Warwick, Department of Economics.
  7. Bertola, Giuseppe & Caballero, Ricardo, 1990. "Target Zones and Realignments," CEPR Discussion Papers 398, C.E.P.R. Discussion Papers.
  8. Bertola, Giuseppe & Caballero, Ricardo, 1991. "Sustainable Intervention Policies and Exchange Rate Dynamics," CEPR Discussion Papers 504, C.E.P.R. Discussion Papers.
  9. Klein, Michael W., 1992. "Big effects of small interventions: The informational role of intervention in exchange rate policy," European Economic Review, Elsevier, vol. 36(4), pages 915-924, May.
  10. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, vol. 80(2), pages 192-96, May.
  11. Francisco Delgado & Bernard Dumas, 1990. "Monetary Contracting Between Central Banks and the Design of SustainableExchange-Rate Zones," NBER Working Papers 3440, National Bureau of Economic Research, Inc.
  12. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August.
  13. repec:fth:coluec:460 is not listed on IDEAS
  14. Robert P. Flood & Andrew K. Rose & Donald J. Mathieson, 1990. "Is the EMS the perfect fix? An empirical exploration of exchange rate target zones," International Finance Discussion Papers 388, Board of Governors of the Federal Reserve System (U.S.).
  15. W. R. M. Perraudin, 1990. "Exchange Rate Bands with Point Process Fundamentals," IMF Working Papers 90/108, International Monetary Fund.
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