Detection of fluctuations bands and their credibility in the EU countries

This paper attempts to identify implicit exchange rate regimes for currencies of European Union accession countries vis-à-vis the euro. To that end, we apply three sequential procedures that consider the dynamics of exchange rates to data covering the period from 1999:01 to 2012:12 for twelve European countries. Our results would suggest that implicit bands have existed in many sub-periods for almost all currencies under study. Once we detect de facto discrepancies between de facto and de iure exchange rate regimes, we make use of Svensson’s (1991) test to study the credibility of the detected fluctuation bands. Our results suggest in most cases that the domestic interest rate deviates quite often above the upper limit of the return band, indicating absence of credibility. The detected lack of credibility in a high percentage of the sample is robust using the Drift Adjustment method and discrete choice models, suggesting that economic agents do not behave as if these bands actually were in force at the time of making their financial plans. We have identified a pattern of behavior among these countries: a trend toward reduction in lack of credibility as we approach to entrance in Exchange Rate Mechanism (ERM) II in most countries. Based on the strong empirical evidence suggesting the predisposition of monetary authorities to deviate with respect to the exchange rate agreement to which they have committed, our main interest in this paper is to review the different methods available to the detect de facto fluctuation bands. To that end, we analyze in depth three alternative sequential procedures based on monthly exchange-rate behavior. Besides three indicators as measures of robustness that have been widely used in the empirical literature we present 3 methods to determine the credibility of the implicit fluctuation bands: Svensson’s (1991) test, Drift Adjustment method and Discrete Choice models.