SSE/EFI Working Paper Series in Economics and Finance,
Stockholm School of Economics

Abstract: This paper is an attempt to explain devaluation expectations in the ERM with macroeconomic fundamentals. Two different measures of devaluation expectations are used; expectations estimated using the drift-adjustment method of Bertola and Svensson [1993] and the directly observable interest rate differential. The interest rate differential seems more closely connected to macroeconomic fundamentals than the estimates stemming from the drift- adjustment metod. For the ERM as a whole, an expanded theoretic model of exchange rate determination explains a considerable part of the devaluation expectations, whereas for individual countries additional variables are important, and the relationships are ambiguous and country specific.

Keywords: Target zones; interest rates; realignments

JEL-codes: E43; E44; F31

30 pages, June 1994

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