This paper studies the Mexican and Israeli experience with a target zone. The first part of the paper develops a model of exchange rate determination under a target zone regime with stochastic realignments, and examines the conditions under which the adoption of the target zone, instead of a fixed exchange rate, reduces the volatility of the interest rate differential. We conclude that if the variance of the expected realignment is sufficiently large, then the target zone will be useful. The second part of the paper is an empirical study that shows that the target zone regime helped reduce interest rate variability in Israel and Mexico by absorbing part of the shocks to the expected realignment with movements of the exchange rate inside the band.

The paper models an adjustable peg exchange rate arrangement as a policy rule with an escape clause under which the timing and magnitudes of realignments are the outcomes of policy optimization decisions. Under the assumptions that market participants are rational, risk averse, and fully informed about the incentives of policymakers, the analysis focuses on the implications for relating realignment expectations to the state variables that enter the policy objective function, for modeling the bias in using forward exchange rates to predict future spot rates, and for characterizing the effectiveness of sterilized intervention.

The paper presents estimates of devaluation expectations for six EMS currencies relative to the Deutsche mark, for the period March 1979-May 1990. The estimation method is simple and operational, and consistently generates sensible results. The estimates are constructed by the adjusting interest rate differentials by subtracting estimated expected rates of depreciation within the exchange rate band. The adjustment is nontrivial because exchange rates within the ERM bands display mean reversion rather than random walk (unit root) behavior. The adjustment is essential since the expected rates of depreciation are usually of about the same magnitude as the interest rate differentials.

This paper examines the volatility and predictability of emerging stock markets. A range of measures suggests that, despite perceptions to the contrary, the volatility of emerging markets may have fallen rather than risen on average. Also, although the autocorrelations in emerging market returns appear to turn negative at horizons of a year or more, the magnitude of these return reversals is not that much larger than reversals in some mature markets. One interpretation of the results would be that emerging markets have not consistently been subject to fads or bubbles, or at least no more so than in some industrial countries.

Handbook of International Economics