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September/October 1994, 
Vol. 76, No. 5
Posted 1994-09-01

Realignments of Target Zone Exchange Rate Systems: What Do We Know?

The recent suspension of the European Union’s Exchange Rate Mechanism (ERM) has led to extensive discussion on the credibility of target zone exchange rate systems. Researchers would like to understand the circumstances associated with speculative attacks and the realignments of target zones for several reasons. For example, monetary authorities would like to maintain stable exchange rates and low inflation while retaining sufficient flexibility to conduct countercyclical stabilization policy. Christopher J. Neely surveys recent work on forecasting realignments and estimating the credibility of target zone exchange rate systems. The literature finds that realignments are somewhat predictable from readily available information such as interest rates and position of the exchange rate within the band. The relationship between realignment expectations and macrovariables—such as output and prices—is weak and uncertain, however. Neely concludes that further work on the formation of expectations would make an important contribution to future research. Additionally, he finds that the role of the U.S. dollar in ERM realignments is often noted but has not yet been incorporated into the estimation techniques.