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Is There a Trade-off between Exchange Rate and Interest Rate Volatility? Evidence from an M-GARCH Model

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  • António Portugal Duarte
  • João Sousa Andrade
  • Adelaide Duarte

Abstract

One of the main implications of the basic target zone model developed by Krugman (1991) is that there is a trade - off between exchange rate volatility and interest rate differential volatility. Using an M- GARCH model we find evidence that such a trade - off existed, prior to the introduction of the euro, between the exchange rate and the interest rate differential among Portugal and Germany. This result reflects the increased credibility of the Portuguese monetary policy, due mainly to the modernisation of the banking and financial system and to the progress made in the disinflation process under an exchange rate target zone.

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  • António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2012. "Is There a Trade-off between Exchange Rate and Interest Rate Volatility? Evidence from an M-GARCH Model," International Journal of Economic Sciences, Prague University of Economics and Business, vol. 2012(1), pages 19-37.
    • Handle: RePEc:prg:jnljes:v:2012:y:2012:i:1:id:25:p:19-37
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    More about this item

    Keywords

    Credibility; disinflation; M-GARCH; volatility and target zones; n/a;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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