Testing the Credibility of the Belgian Hard Currency Policy

IMF Working Papers, August 1, 1991

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Interest rate differentials have been widely used to assess the degree of policy credibility.
The paper identifies a problem: the relationship between the differential and credibility varies not only across maturities but also with the actual level of the exchange rate.
An alternative approach is proposed, based on the construction of rate-of-return bands, to overcome this difficulty.
Application: Belgium, which in May 1990 hardened its exchange rate policy stance.
Comparisons are made with other small, open European economies.

Constructs rate-of-return bands as an alternative to relying solely on interest rate differentials.
Uses econometric analysis to test whether announcement and active implementation of a tighter exchange rate link affect credibility.

The rate-of-return bands approach overcomes the sensitivity of interest rate differentials to maturity and exchange rate level.
Econometric evidence is provided supporting the claim that the announcement and active implementation of a tighter exchange rate link does make a difference.
The approach is applied to Belgium’s May 1990 policy hardening and compared with other small, open European economies.

Subjects: Currencies; Economic and financial statistics; Exchange rates; Financial services; Financial statistics; Foreign exchange; Long term interest rates; Money; Public debt
Keywords: band vis-à-vis; Currencies; Danish krone; debt ratio; deutsche mark rate; Exchange rates; Financial statistics; inflation differential; interest rate; interest rate differential; Long term interest rates; mechanism of the EMS; short term exchange rate volatility; vis-à-vis Germany; WP