Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models
A time-varying stochastic devaluation risk is introduced in a model of exchange rate target zones. The model produces realistic patterns of covariation between exchange rates and interest rate differentials, which previous target zone models have been unable to do. A 'drift adjustment' method to estimate devaluation expectations from data is suggested. Copyright 1993 by The Review of Economic Studies Limited.
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