Noisy signals in target zone regimes: Theory and Monte Carlo experiments

Previous empirical evidence indicates that uncovered interest parity (UIP) does not hold for target zone exchange rates, like those in the European Mo netary System and in the Nordic countries. We explore a target zone model w here the market infers the probability of a realignment of the band on the basis of a noisy signal. We show theoretically and through Monte Carlo simu lations that if the market overrates the information content in the signal, then this may explain the empirical results obtained from testing UIP for target zone exchange rates. (C) 1999 Elsevier Science B.V. All rights reser ved. JEL classification: E34; G14; D84; C15.