Empirical studies of the exchange rate policies of EMS member countries or of non-member countries that have unilaterally pegged their currencies to the ecu such as Sweden have not borne out the predictions of Krugman's simple `target zone' model (see Bulletin 47/48 for a discussion of such models). Such models leave unexplained a strongly serially correlated component in the relationship between exchange rates and interest rate differentials, and their disappointing empirical performance has encouraged researchers to augment them to allow the devaluation risk to vary over time. This provides an interesting interpretation of the remaining unexplained variability.

In Discussion Paper No. 611, Research Fellow Axel Weber tests these more sophisticated models and finds that stochastic devaluation risk provides a good explanation of the relationship between the EMS member currencies' exchange rates vis-à- vis the Deutschmark and the corresponding interest rate differentials. He first uses regression equations with time- varying parameters on interest and exchange rate data to estimate the unobservable expected devaluation rates, which he finds to be only imperfectly correlated with interest rate differentials. These have also declined significantly in recent years, which indicates that the credibility of the EMS has increased. He then shows that there is no clear relationship between the observed interest rate differential and the exchange rate's position in the band of the type the early target zone models predict; but there is a clear and almost noise-free empirical relationship once interest rate differentials are adjusted for time-varying rates of expected devaluation. This striking result provides strong support for the `second generation' of target zone models.

Weber also notes that estimates of expected devaluation rates have recently declined significantly, but such risks have not yet been eliminated completely. Also, while Weber's estimates of expected devaluation rates suggest that the market anticipated some of the early EMS realignments (in particular the Belgian, Danish and Italian realignments), his results for France, Ireland and the Netherlands indicate that realignment expectations under speculative attacks account for only small proportions of expected devaluation rates. This implies that these currencies' realignments relative to the Deutschmark were for the most part not anticipated by the market.

Time-Varying Devaluation Risk, Interest Rate Differentials and Exchange Rates in Target Zones: Evidence from the EMS
Axel A Weber

Discussion Paper No. 611, January 1992 (IM)