An Empirical Exploration of Exchange Rate Target-Zones

IMF Working Papers, February 1, 1991

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In the context of a flexible-price monetary exchange rate model and the assumption of uncovered interest parity, the authors obtain a measure of the fundamental determinant of exchange rates.
Daily data for the European Monetary System are used to explore the importance of nonlinearities in the relationship between the exchange rates and fundamentals.
Many implications of existing “target-zone” exchange rate models are tested; little support is found for existing nonlinear models of limited exchange rate flexibility.

Framework: flexible-price monetary exchange rate model.
Key assumption: uncovered interest parity.
Objective: obtain a measure of the fundamental determinant of exchange rates and test model implications empirically.

The empirical exploration focuses on the importance of nonlinearities in the relationship between exchange rates and fundamentals.
Tests of many implications of existing “target-zone” exchange rate models yield little support for existing nonlinear models of limited exchange rate flexibility.

Subject: Crawling peg, Exchange rate arrangements, Exchange rate modelling, Exchange rates, Foreign exchange, Managed exchange rates.
Keywords: Crawling peg, EMS, Exchange rate arrangements, exchange rate band, exchange rate fundamental, Exchange rate modelling, exchange rate volatility, exchange rates, interest rate, interest rate differential, interest rate volatility, Managed exchange rates, natural logarithm, nonlinear, position graph, risk premium, target-zone., WP