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Simple credibility tests of the ERM bands for the pound sterling and the Italian lira

  • Elias Belessakos
  • Michael Papaioannou
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    This article presents evidence that the European Monetary System (EMS) bands for the Italian lira and the pound sterling were not credible for most of the period 1990–1992, and especially during the week prior to their withdrawal from the EMS system. Using a simple test, developed by Svensson, domestic interest rates for both Italy and the United Kingdom have been found to be mostly outside the rate-of-return bands implied by the official arrangements of the EMS target zone system. Furthermore, comparing implied forward rates for various maturities with the official EMS bands of both currencies, we again found that the followed monetary policies in both countries were not in general consistent with those needed to maintain an orderly functioning of the (EMS) system. The Svensson test can further be used as an indicator of potential speculative attacks on an EMS currency, and, in turn, as a signal of an emerging need to adjust the corresponding country's monetary policy. Copyright Kluwer Academic Publishers 1996

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    Article provided by Springer in its journal Open Economies Review.

    Volume (Year): 7 (1996)
    Issue (Month): 3 (July)
    Pages: 219-236

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    Handle: RePEc:kap:openec:v:7:y:1996:i:3:p:219-236
    Contact details of provider: Web page: http://www.springerlink.com/link.asp?id=100323

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    1. Lars E.O. Svensson, 1990. "The Simplest Test of Target Zone Credibility," NBER Working Papers 3394, National Bureau of Economic Research, Inc.
    2. O'Connell, Joan, 1988. "Sterilization and interest rates," Journal of International Money and Finance, Elsevier, vol. 7(4), pages 425-428.
    3. Giavazzi, Francesco & Pagano, Marco, 1986. "The Advantages of Tying One's Hands: EMS Discipline and Central Bank Credibility," CEPR Discussion Papers 135, C.E.P.R. Discussion Papers.
    4. Vincent Koen, 1991. "Testing the Credibility of the Belgian Hard Currency Policy," IMF Working Papers 91/79, International Monetary Fund.
    5. Svensson, L.E., 1990. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," Papers 475, Stockholm - International Economic Studies.
    6. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, vol. 76(1), pages 72-81, March.
    7. Bartolini, Leonardo & Bodnar, Gordon M., 1992. "Target zones and forward rates in a model with repeated realignments," Journal of Monetary Economics, Elsevier, vol. 30(3), pages 373-408, December.
    8. Gordon M. Bodnar & Leonardo Bartolini, 1992. "Target Zones and Forward Rates in a Model with Repeated Realignments," IMF Working Papers 92/22, International Monetary Fund.
    9. Andrew K. Rose & Lars E.O. Svensson, 1993. "European Exchange Rate Credibility Before the Fall," NBER Working Papers 4495, National Bureau of Economic Research, Inc.
    10. 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.
    11. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August.
    12. Zhaohui Chen & Alberto Giovannini, 1992. "Estimating Expected Exchange Rates Under Target Zones," NBER Working Papers 3955, National Bureau of Economic Research, Inc.
    13. Barry Eichengreen & Charles Wyplosz, 1993. "The Unstable EMS," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 24(1), pages 51-144.
    14. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-36, June.
    15. Robert P. Flood & Peter M. Garber, 1989. "The Linkage Between Speculative Attack and Target Zone Models of Exchange Rates," NBER Working Papers 2918, National Bureau of Economic Research, Inc.
    16. Lindberg, H. & Soderlind, P., 1991. "Testing the Basic Target Zone Model on Swedish Data," Papers 488, Stockholm - International Economic Studies.
    17. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August.
    18. Gordon M. Bodnar & Leonardo Bartolini, 1992. "An Analysis of the Process of Capital Liberalization in Italy," IMF Working Papers 92/27, International Monetary Fund.
    19. Lazaros E. Molho, 1991. "The Italian Lira in the Narrow Erm Band; The Challenge of Credibility," IMF Working Papers 91/19, International Monetary Fund.
    20. Francesco Caramazza, 1993. "French-German Interest Rate Differentials and Time-Varying Realignment Risk," IMF Working Papers 93/1, International Monetary Fund.
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