EXPECTED DEVALUATION AND ECONOMIC FUNDAMENTALS

Recent incidents of exchange rate collapse have provoked interest in h ow much these events are determined by economic fundamentals. This pap er considers whether interest rate differentials are appropriate measu res of the risk of devaluation and whether this measure of devaluation risk reflects the movements of variables that capture internal and ex ternal balance. The paper finds that interest rate differentials refle ct devaluation risk but that movements in fundamental variables in Fra nce and Italy have only a weak effect on devaluation risk. The most si gnificant influence on devaluation risk is the position of the currenc y in its band in that the lower the exchange value of a currency is wi thin the band, the greater is the perceived risk of devaluation.