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Regime-switching and interest rates in the European monetary system
Journal article   Peer reviewed

Regime-switching and interest rates in the European monetary system

Magnus Dahlquist and Stephen F. Gray
Journal of International Economics, Vol.50(2), pp.399-419
2000-04-01

Abstract

Interest rate modeling Regime shifts Target zone credibility
This paper examines the impact that a currency target zone has on short-term interest rates. For a number of countries in the European Monetary System, we characterize the short rate using a regime-switching model that allows for a differently parameterized mean-reverting square-root process in each regime. We find that the volatility, the level, and the speed-of-adjustment are all higher in the regime that is operative during speculative attacks and currency crises. Moreover, we allow the conditional probability of being in each regime to be state-dependent so the model can be used to examine questions relating to the likelihood of realignments and the stability of the target zone system.

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