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Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models

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  • Bertola, G.
  • Svensson, L.E.

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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Suggested Citation

  • Bertola, G. & Svensson, L.E., 1990. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," Papers 481, Stockholm - International Economic Studies.
  • Handle: RePEc:fth:stocin:481
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    References listed on IDEAS

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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. 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.).
    3. 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.
    4. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, vol. 80(2), pages 192-196, May.
    5. Miller, M. & Weller, P., 1988. "Exchange Rate Bands And Realignments In A Stationary Stochastic Setting," The Warwick Economics Research Paper Series (TWERPS) 317, University of Warwick, Department of Economics.
    6. Froot, Kenneth A. & Obstfeld, Maurice, 1991. "Exchange-rate dynamics under stochastic regime shifts : A unified approach," Journal of International Economics, Elsevier, vol. 31(3-4), pages 203-229, November.
    7. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-536, June.
    8. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 669-682.
    9. Francisco Delgado & Bernard Dumas, "undated". "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.
    10. Shula Pessach & Assaf Razin, 1991. "Targeting the Exchange Rate: An Empirical Investigation," NBER Working Papers 3662, National Bureau of Economic Research, Inc.
    11. Bertola, Giuseppe & Caballero, Ricardo, 1991. "Sustainable Intervention Policies and Exchange Rate Dynamics," CEPR Discussion Papers 504, C.E.P.R. Discussion Papers.
    12. 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.
    13. W. R. M. Perraudin, 1990. "Exchange Rate Bands with Point Process Fundamentals," IMF Working Papers 90/108, International Monetary Fund.
    14. 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.
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