The credibility of the Colombian exchange rate target zone: Its impact over the volatility of interest rate differentials

This paper analyzes the credibility of Colombia’s exchange rate target zone, and in particular its impact on the volatility of interest rate differentials. Bertola and Caballeros’ (1995) model of a target zone with imperfect credibility is used to derive the impact of a reduction in credibility over the variance of the interest rate differential. It is theoretically shown, that as credibility decreases the variance of the interest rate differential increases. This theoretical argument is used to estimate credibility in Colombia’s exchange rate target zone. Using a SWARCH model, the probability of being in a regime with high interest rate volatility is estimated, and is related with events in the exchange rate market. Results suggest that there is evidence of lack of credibility even before the recent international financial turmoil was triggered.