NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Assessing Target Zone Credibility: Mean Reversion and Devaluation Expectations in the ERM 1979-1992

Lars E.O. Svensson

NBER Working Paper No. 3795 (Also Reprint No. r1840)
Issued in July 1991
NBER Program(s):   ITI   IFM

The paper presents estimates of devaluation expectations for six EMS currencies relative to the Deutsche mark, for the period March 1979-May 1990. The estimation method is simple and operational, and consistently generates sensible results. The estimates are constructed by the adjusting interest rate differentials by subtracting estimated expected rates of depreciation within the exchange rate band. The adjustment is nontrivial because exchange rates within ERM bands display mean reversion rather than random walk (unit root) behavior. The adjustment is essential since expected rates of depreciation within the band are usually of about the same magnitude as interest rate differentials.

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Document Object Identifier (DOI): 10.3386/w3795

Published: European Economic Review, Vol. 37, p. 763-793 (1993)

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