The currency band and credibility : The Finnish experience

Abstract

This paper examines developments in the Finnish money and foreign exchange markets in the light of the recent literature on target-zones. The basket-pegging system, which was officially adopted in Finland in late 1977, provides a good opportunity to discuss some of the implications of the target-zone models. Analysis concentrates on the period after 1987 when the assumptions underlying the basic target-zone model can assumed to be fulfilled. Although empirical exchange rate distributions of the Finnish markka do not seem to resemble those predicted by the basic target-zone model, the findings of the paper support the view that for a given period Finnish data exhibit some of the implications of target-zone models. The results, however, indicate that causality rons from the interest rate differential to the exchange rate and not from the exchange rate to the interest rate differential as implied by the basic (credible) target-zone model. In addition, intervention practices carried out by the central bank appear to have played an important role in determining the expected future exchange rate within the currency band.