The Credibility of a Fixed Exchange Rate: How Reputation Is Gained or Lost.

The authors examine the interest rate differential between each of the four largest Nordic countries and the countries of their foreign currency baskets on monthly data for the period 1978/79-92. The interest rate differential is assumed to reflect devaluation expectations, which partly depend on government reputation. The authors investigate the formation of the reputation of the government, assuming that reputation is updated using Bayes's formula. It is shown theoretically that, when there is no devaluation, the improvement in government reputation is larger, the larger the prior devaluation expectations. For Norway, the evidence gives support to this assertion. Copyright 1996 by The editors of the Scandinavian Journal of Economics.