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Title: The Simplest Test of Target Zone Credibility

Author(s): Lars E.O. Svensson

Publication Date: January 1991

Keyword(s): Credibility, Devaluation Risk, Exchange Rates, Interest Rate Bands, Target Zones and Term Structure

Programme Area(s): International Macroeconomics

Abstract: Under the assumption of no arbitrage, exchange rate target-zone credibility is tested by whether domestic interest rates fall within `rate-of-return bands' between the maximum and minimum home-currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest rate parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. Under the assumption that devaluations are a Poisson process, the expected exchange rate, the probability intensity and the expected size of a devaluation can be related. These tests are illustrated using data on the Swedish target zone between January 1987 and August 1990.

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Bibliographic Reference

Svensson, L. 1991. 'The Simplest Test of Target Zone Credibility'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=493