Magnus Dahlquist
Stockholm Institute of Economics, Stockholm, Sweden
Stephen Gray
Fuqua School of Business, Duke University, Durham, NC 27708
Abstract
In this paper we examine the effects of exchange rate target zones on the dynamics of short-term interest rates. We show that, in contrast to existing models, the regime-switching model developed is able to capture the behavior of interest rates for countries in the European Monetary System (EMS) around target zone realignments. The regimes are interpreted in terms of "non-credible/speculative attack" regimes and "credible system" regimes. Further, we allow the regime-switching probabilities to be state-dependent, and the model can be used to examine questions relating to the likelihood of realignments and the stability of the target zone system. The behavior of interest rates in the EMS is compared with the behavior of interest rates in the United States.