A credible target zone exchange rate regime with a given exchange rate band implies
bounds on the amount of depreciation and appreciation of the domesticcurrency. 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.
*Published:
International Monetary Fund Staff Papers, Vol. 38, No. 3, pp. 655-665, (September 1991).
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