Target zone credibility and economic fundamentals

This paper investigates empirically the relationship between target zone credibility and economic fundamentals using French monthly data for the period 1991:6 to 1998:9. The econometric framework is one which allows expected devaluation (proxied by the interest rate differential) to stochastically switch between a 'high' and a 'low' phase according to the outcome of a Markov process. The transition probabilities of the Markov process are assumed to vary over time as a functions of various monetary and real macroeconomic variables. Our findings suggest that expected devaluation is significantly influenced by foreign reserves and the deviations of the exchange rate from the EMS central parity, whereas the effects of real variables are weak at best