DP580 Assessing Target Zone Credibility: Mean Reversion and Devaluation Expectations in the EMS

Author(s): Lars E.O. Svensson
Publication Date: July 1991
Keyword(s): EMS, Exchange Rate, Mean Reversion, Realignment, Target Zone, Unit Root Devaluation
JEL(s): F31, F33
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=580

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