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Bands width, credibility and exchange risk: Lessons from the EMS experience

By Marta Gómez Puig and José García Montalvo

Abstract

This paper presents an analysis of the credibility of the EMS currencies that covers the period before and after the increase in the bands of fluctuation. Our credibility indicator is based on the inferred probabilities derived from the estimation of a Markov-switching model (Hamilton (1989)) applied to the expected rate of depreciation. The results show that, for most of the currencies, credibility has improved, at least transitorily, after the increase in the bands. However, for all currencies, the credibility measured by the indicator proposed in this paper has been eroded recently even with the widened bands.

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