Scandinavian Working Papers in Economics

Discussion Papers,
Statistics Norway, Research Department

No 160: Noisy signals in target zone regimes Theory and Monte Carlo experiments

Steinar Holden, Dag Kolsrud and Birger Vikøren
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Birger Vikøren: Statistics Norway

Abstract: Previous empirical evidence indicates that uncovered interest rate parity (UIP) does not hold for target zone exchange rates, like those in the European Monetary System and in the Nordic countries. We explore a target zone model where the market inferes the probability of a realignment of the band on the basis of a noisy signal. We show theoretically and through Monte Carlo simulations that if the market overrates the information content in the signal, then this may explain the empirical results obtained from testing UIP for target zone exchange rates.

Keywords: Monte Carlo; target zones; uncovered interest parity.

JEL-codes: C12; C15; F31; G14 December 1995

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