An econometric diffusion model of exchange rate movements within a band : implications for interest rate differential and credibility of exchange rate policy

The paper presents a model ofexchange rate movements within a specified exchange rate band enforced by central bank interventions. The model is based on the empirical observation that the exchange rate has usually been strictly inside the band, at least in Finland. In this model the distribution of the exchange rate is truncated lognormal from the edges towards the center of the band and hence quite different from the bimodal distribution of the standard target zone model. The model is estimated using the daily observations of the changes in the FIM exchange rate since 1987. The estimated model is used to compute the expected future values of the FIM/ECU rate within the band for the period June 7, 1991- September 7, 1992 and the corresponding interest rate differential between Finland and EMS countries. Subtracting this from the actual interest rate differential gives a measure of expected devaluation and devaluation risk premium. The premium was very large in autumn 1991 before the devaluation in November but afterwards it decreased considerably. After a few months the devaluation pressure increased again and finally on September 8, 1992 markka was allowed to float.