The Simplest Test of Target Zone Credibility

Under the assumption of no arbitrage, the credibility of an exchange rate target zone is tested by whether domestic interest rates fall within "rate-of-return bands" between the maximum and minimum home currency rate of return on a foreign investment in the absence of a devaluation. Under the assumption of uncovered interest parity, credibility is tested by whether expected future exchange rates fall within the exchange rate band. These tests are applied on data on the Swedish target zone from January 1987 through August 1990.