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The Simplest Test of Target Zone Credibility

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  • Lars E.O. Svensson

Abstract

A credible target zone exchange rate regime with a given exchange rate band implies bounds on the amount of depreciation and appreciation of the domestic currency. This implies, for given foreign interest rates, bounds on the domestic-currency rate of return on foreign investment: a rate-of-return band for each time to maturity. Whether domestic interest rates are outside these rate-of-return bands can be used as a simple test of exchange rate credibility, under the assumption of sufficient international capital mobility. This test is applied to the Swedish target zone during February 1986-February 1990. Under the additional assumption of uncovered interest rate parity, an equivalent test is whether expected future exchange rates are outside the exchange rate band. In addition, the expected future exchange rates are used to give an estimate of the probability of future devaluations.

Suggested Citation

  • Lars E.O. Svensson, 1990. "The Simplest Test of Target Zone Credibility," NBER Working Papers 3394, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:3394
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    References listed on IDEAS

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    1. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August.
    2. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
    3. Svensson, Lars E. O., 1991. "The term structure of interest rate differentials in a target zone : Theory and Swedish data," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 87-116, August.
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    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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