Explaining devaluation expectations in the EMS

This paper is an attempt to explain devaluation expectations in the ERM with macroeconomic fundamentals. Two different measures of devaluation expectations are used; expectations estimated using the drift-adjustment method of Bertola and Svensson (1993), and the directly observable interest rate differential. The interest rate differential seems more closely connected to macroeconomic fundamentals than the estimates stemming from the drift-adjustment method. For the ERM as a whole, an expanded monetary model of exchange rate determination explains a considerable part ofthe devaluation expectations, whereas for individual countries additional variables are important, but the relationships are ambiguous and country-specific.