ESTIMATING THE CREDIBILITY OF AN EXCHANGE-RATE TARGET ZONE

Recent breakthroughs in the theory of exchange rate target zones have not been followed by similar contributions on the empirical side. The drift adjustment method of evaluating the credibility of a target zone has become common practice. However, the estimates of the expected ra te of depreciation inside the band do not model knowledge of the band in the agents' information set. In this paper, a rational expectations limited-dependent variable method to estimate the expected rate of de preciation is used to remedy this weakness. In the case of the fi-anc- mark target zone with daily data covering a 4-year period, we show tha t expected rates of devaluation of the order of 2.5% were still presen t in the early 1990s. Their reappearance in the autumn of 1992 may thu s not be surprising. (C) 1997 Elsevier Science Ltd. All rights reserve d.