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Noisy signals in target zone regimes Theory and Monte Carlo experiments

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Abstract

Previous empirical evidence indicates that uncovered interest rate parity (UIP) does not hold for target zone exchange rates, like those in the European Monetary System and in the Nordic countries. We explore a target zone model where the market inferes the probability of a realignment of the band on the basis of a noisy signal. We show theoretically and through Monte Carlo simulations that if the market overrates the information content in the signal, then this may explain the empirical results obtained from testing UIP for target zone exchange rates.

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Bibliographic Info

Paper provided by Research Department of Statistics Norway in its series Discussion Papers with number 160.

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Date of creation: Dec 1995
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Handle: RePEc:ssb:dispap:160

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Keywords: Monte Carlo; target zones; uncovered interest parity.;

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  1. Flood, Robert P & Rose, Andrew K, 1994. "Fixes: Of the Forward Discount Puzzle," CEPR Discussion Papers 1090, C.E.P.R. Discussion Papers.
  2. Tversky, Amos & Thaler, Richard H, 1990. "Anomalies: Preference Reversals," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 201-11, Spring.
  3. Krasker, William S., 1980. "The `peso problem' in testing the efficiency of forward exchange markets," Journal of Monetary Economics, Elsevier, vol. 6(2), pages 269-276, April.
  4. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(4), pages 831-72, August.
  5. Svensson, L.E., 1990. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," Papers, Stockholm - International Economic Studies 475, Stockholm - International Economic Studies.
  6. Charles Engel, 1995. "Why is the forward exchange rate forecast biased? A survey of recent evidence," Research Working Paper, Federal Reserve Bank of Kansas City 95-06, Federal Reserve Bank of Kansas City.
  7. Bertola, Giuseppe & Svensson, Lars E O, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(3), pages 689-712, July.
  8. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  9. Rose, A.K. & Svensson, L.E., 1991. "Expected and Predicted Realignments: the FF/DM Exchange Rate during the EMS," Papers, Stockholm - International Economic Studies 485, Stockholm - International Economic Studies.
  10. Lewis, Karen K, 1989. "Changing Beliefs and Systematic Rational Forecast Errors with Evidence from Foreign Exchange," American Economic Review, American Economic Association, vol. 79(4), pages 621-36, September.
  11. De Bondt, Werner F M & Thaler, Richard H, 1990. "Do Security Analysts Overreact?," American Economic Review, American Economic Association, vol. 80(2), pages 52-57, May.
  12. Pesaran, M. Hashem & Samiei, Hossein, 1992. "Estimating limited-dependent rational expectations models with an application to exchange rate determination in a target zone," Journal of Econometrics, Elsevier, vol. 53(1-3), pages 141-163.
  13. De Grauwe, Paul, 1989. "On the Nature of Risk in the Foreign Exchange Markets: Evidence from the Dollar and the EMS Markets," CEPR Discussion Papers 352, C.E.P.R. Discussion Papers.
  14. Mundaca, B Gabriela, 1991. " The Volatility of the Norwegian Currency Basket," Scandinavian Journal of Economics, Wiley Blackwell, vol. 93(1), pages 53-73.
  15. Drazen, Allan & Masson, Paul R, 1994. "Credibility of Policies versus Credibility of Policymakers," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 109(3), pages 735-54, August.
  16. Holden, Steinar & Vikoren, Birger, 1994. " Interest Rates in the Nordic Countries: Evidence Based on Devaluation Expectations," Scandinavian Journal of Economics, Wiley Blackwell, vol. 96(1), pages 15-30.
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Cited by:
  1. Sverre Grepperud, 1997. "Soil Depletion Choices under Production and Price Uncertainty," Discussion Papers, Research Department of Statistics Norway 186, Research Department of Statistics Norway.
  2. Steinar Holden, 2012. "Implications of insights from behavioral economics for macroeconomic models," IMK Working Paper 99-2012, IMK at the Hans Boeckler Foundation, Macroeconomic Policy Institute.

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