Stochastic process switching and intervention in exchange rate target zones : empirical evidence from the EMS

In exchange rate target zone models the commitment of policymakers to intervene at the boundaries of the band gives rise to speculation which stabilizes exchange rates within the band. The empirical implications of such stochastic process switching are discussed and their relevance for the European Monetary System (EMS) is evaluated by using Bayesian inference. The estimates of realignment and intervention probabilities obtained from daily German mark EMS exchange rates indicate that realignment probabilities in the EMS have recently declined drastically and that the system is now close to being a fully credible peg.