Detecting undeclared target zones within the European Monetary System

Abstract

International agreements such as the European Monetary System require the exchange rates to lie inside target zones. In particular, when the bands are sufficiently large, monetary Authorities could intervene in order to defend a specific and generally undeclared target zone which is different from the institutional target zone. In this paper the existence of such undeclared target zones is investigated by developing a statistical procedure within the framework of the theory of reflected Brownian motions. In order to evaluate Central Banks interventions, a test for the null hypothesis of no undeclared target zones is suggested. By analyzing the EMS exchange rates it arises that only a few Central Banks defend the institutional target zone, while the others defend narrower bands.