Essays on the European exchange rate target zone

The first essay applies a limited dependent variable rational expectations model to estimate the French Franc/Deutsche Mark (FF/DM) exchange rate in order to test the credibility of the European Exchange Rate Mechanism (ERM) for these currencies.; I find considerable support for modeling the exchange rate using a limited dependent variable framework. The results indicate that accounting for the band significantly modifies the results of credibility tests. As opposed to earlier findings in the literature, confidence intervals for the expected realignment are wider than those resulting from ordinary least squares estimates and from a rational expectations model obtained without imposing the band. Furthermore, the results trace the history of the ERM realignments for the FF/DM and in each case correctly identify the period before and after a realignment as a period lacking credibility.; In the second essay I model central rate realignments in the European exchange rate target zone in order to estimate both the time varying probability and the size of a realignment using the Kalman filter within the context of a limited dependent variable framework.; The central rate in a target zone is assumed to be realigned when adverse shocks to the economy cannot be contained and warrant a devaluation. The policymakers have to decide whether they will realign or not and, if they do, they must determine the size of the realignment. The reaction of policymakers to changing economic circumstances is estimated using a time varying parameter framework.; The model forecasts almost all of the realignments with high accuracy and improves upon a constant parameter model in terms of forecasting power. Depletion of foreign exchange reserves, a weak position of the spot rate within the band and an expansionary monetary policy are found to be the main driving forces behind realignments. The size of realignments is strongly affected by real exchange rates and by the size of shocks that trigger a realignment response from the policymakers.