While many theoretical models take as given the relationships between the credibility of parities under fixed exchange rates and underlying macroeconomic variables, these have been subject to little empirical investigation. In Discussion Paper No. 852, Research Fellows Andrew Rose and Lars Svensson investigate these linkages for various proxy measures of realignment expectations and discuss their movements before and during the European currency crisis of 1992.

They consider four highly correlated proxies: daily data on interest rate differentials with Germany for one- and three-month maturities, both `raw' and adjusted for the expected exchange rate drift. They estimate the latter by a linear regression that links exchange rate changes to interest rates and the exchange rate level. Pooling data across countries and time, they search for statistically and economically significant links between credibility and six macroeconomic variables (money, output, inflation, competitiveness, reserves and the trade balance) and the degree to which central banks exploit monetary independence. Only inflation differentials display a strong and consistent linkage with credibility.

Rose and Svensson maintain that these apparently disappointing results fit quite well with recent European experience. Strong ties would suggest that the parities' credibility should have decayed slowly, at least for Italy and the UK, while evidence is strong that neither policy-makers nor the markets anticipated the crisis. Later speculative attacks on the French franc are also inconsistent with strong linkages, which are also unable to account for the timing of the crisis. Rose and Svensson further show that realignment expectations displayed no strong reaction to the first Danish referendum result or the polls monitoring the French vote. Like many floating exchange rates, ERM credibility often reacts to economic non-events and does not respond consistently to events that economic theory suggests should prove important.

European Exchange Rate Credibility Before the Fall
Andrew K Rose and Lars E O Svensson

Discussion Paper No. 852, November 1993 (IM)