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

31 Pages Posted: 28 Dec 2006 Last revised: 16 Nov 2022

See all articles by Lars E. O. Svensson

Lars E. O. Svensson

Stockholm School of Economics; Stockholm University - Institute for International Economic Studies (IIES); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Date Written: July 1991

Abstract

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.

Suggested Citation

Svensson, Lars E.O., Assessing Target Zone Credibility: Mean Reversion and Devaluation Expectations in the Erm 1979-1992 (July 1991). NBER Working Paper No. w3795, Available at SSRN: https://ssrn.com/abstract=473947

Lars E.O. Svensson (Contact Author)

Stockholm School of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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