This paper examines the credibility of the exchange rate bands in Nordic countries during 1987-91. Its method consists of two separate tests. The first test assumes only that all arbitrage opportunities in the market have been exhausted; the second test uses in addition the assumption of uncovered interest rate parity. The results of these two tests are expressed in the same diagram in terms of forward exchange rates.
The first test defines a rate-of-return band for foreign investment with a given maturity. If the domestic interest rate for a given maturity falls outside the rate-of-return band, the exchange rate band is not considered credible as there would be unexploited profit opportunities should the market believe in the peg. The second test assumes uncovered interest rate parity so that the credibility of the exchange rate band can be quantified. The computed forward exchange rate is equal to the expected future exchange rate, and the further it is from the limits of the official exchange rate band, the less credible is the band.
The results show that Finland’s exchange rate was credible during most of the period. Forward exchange rates indicated, however, a sharp deterioration and a lack of credibility in the months preceding the devaluation of the markka in November 1991. Denmark’s and Norway’s bands lacked credibility at the beginning of the period, but credibility was restored from 1989 for Norway and as of 1990 for Denmark. Credibility of Sweden’s band could not be rejected up to the fall of 1989, but thereafter it deteriorated sharply.
In conclusion, the hypothesis cannot be rejected that participation in the multilateral exchange rate mechanism (ERM) has brought Denmark credibility. However, ERM membership has not brought Denmark immediate credibility. As Norway achieved an even more impressive increase in the credibility of its exchange rate band, the hypothesis that a unilateral exchange rate arrangement can be credible also cannot be rejected. The recent move to European currency unit (ECU) pegs in Norway, Sweden, and Finland were associated with an increase in credibility. But in all cases, credibility deteriorated again in the period following the change in the peg and, in Finland, the exchange rate was finally devalued. These experiences suggest that at least part of the improvement in credibility was due to a temporary announcement effect. A firmer commitment than a unilateral peg may be necessary for sustained credibility.