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The European Monetary System: Credible at Last?

  • Jeffrey Frankel
  • Steven Phillips

We update tests of the credibility of the EMS exchange rate target zones. Our main methodological innovation is to use a survey of exchange rate forecasts, as well as interest differentials, in measuring exchange rate expectations. We investigate the hypothesis -- suggested by the apparent stabilization of the EMS and by recent institutional developments -- that the EMS target zones have experienced an increase in credibility since their 1987 realignment. The evidence tends to support this hypothesis for most currencies. We also examine the empirical failure of standard target zone models, but find no evidence that it can be attributed to mismeasurement of expectations. Finally, we consider an alternative credibility measure which captures the importance of possible realignments in overall expectations of exchange rate changes.

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File URL: http://www.nber.org/papers/w3819.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 3819.

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Date of creation: Aug 1991
Date of revision:
Publication status: published as Oxford Economic Papers: 44, 1992, 791-816
Handle: RePEc:nbr:nberwo:3819
Note: ITI IFM
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  1. Froot, Kenneth A. & Frankel, Jeffrey A., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Department of Economics, Working Paper Series qt5w65g4zg, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  2. Lars E.O. Svensson, 1990. "The Simplest Test of Target Zone Credibility," NBER Working Papers 3394, National Bureau of Economic Research, Inc.
  3. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 669-682.
  4. Svensson, Lars E O, 1991. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," CEPR Discussion Papers 494, C.E.P.R. Discussion Papers.
  5. Lars E.O. Svensson, 1990. "The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data," NBER Working Papers 3374, National Bureau of Economic Research, Inc.
  6. Alberto Giovannini & Philippe Jorion, 1988. "The Time-Variation of Risk and Return in the Foreign Exchange and Stock Markets," NBER Working Papers 2573, National Bureau of Economic Research, Inc.
  7. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  8. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
  9. Bertola, G. & Svensson, L.E., 1990. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," Papers 481, Stockholm - International Economic Studies.
  10. Giovannini, Alberto, 1988. "The Time Variation of Risk and Return in the Foreign Exchange and Stock Markets," CEPR Discussion Papers 228, C.E.P.R. Discussion Papers.
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