Policy credibility in the ERM: evidence from six countries using an ARCH approach

Abstract

The issue of credibility and capital mobility in the EMS is re-examined using an alternative methodology, as well as a longer sample period than previous studies. In particular, the dynamic relationship between interest rate differentials and the exchange rate risk premium is emphasized. The relationship between the premium and credibility is then used in order to identify patterns of credibility in ERM countries. Credibility in the case of Italy has declined post-1985, as indicated by the rising exchange rate risk premium. For Denmark, France and Ireland, credibility seems to be increasing up to the currency crisis period and for Belgium and Holland credibility increased early in the period and remained high during the rest of the period.