Determinants of the Implied Shadow Exchange Rates from a Target Zone

The paper provides a continuous-time model of the dynamic behavior of exchange rates and interest rates when exchange rates are managed within a target zone with the possibility of realignments. In the case of a realignment the exchange rate jumps to a shadow exchange rate. The timing of realignments is modelled by a Cox process with an intensity that depends on the location of the exchange rate in the target zone band as well as the distance to the shadow exchange rate. We set up an approximate maximum likelihood estimation approach and provide parameter estimates for six ERM target zones. Moreover, in the empirical analysis we "lter out the shadow exchange rates and investigate which fundamental macroeconomic factors are able to explain the short-run and long-run behavior of the "ltered shadow exchange rates.