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Testing for Nonlinear Adjustment in the Portuguese Target Zone: Is there a Honeymoon Effect?

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  • António Portugal Duarte

    ()
    (Faculty of Economics University of Coimbra and GEMF, Portugal)

  • João Sousa Andrade

    ()
    (Faculty of Economics University of Coimbra and GEMF, Portugal)

  • Adelaide Duarte

    ()
    (Faculty of Economics University of Coimbra and GEMF, Portugal)

Abstract

The aim of this paper is to examine to what extent the adoption by Portugal of an exchange rate target zone regime in the context of its participation in the ERM of the EMS can be characterised by the existence of a nonlinear S-shaped relationship between the exchange rate and its fundamental. If there is such a relationship, a target zone would have a stabilising effect on the exchange rate, the so-called ‘honeymoon effect’, as predicted by the basic target zone model developed by Krugman (1991). We tested three models: OLS, Auto-correlation by Maximum Likelihood and GARCH (p, q). However, the evidence of a negative trend in the interest rate differential prevented the empirical confirmation of a nonlinear relationship. The use of LSTAR and ESTAR models also failed to reconcile the theory with the data. This does not mean that a stabilising effect on the exchange rate had not happened. Portugal’s current participation in the EMU is demonstrative of this reality. Maintaining a downward trend in interest rate differential turns out to reflect the increased credibility in the conduct of monetary policy, allowing the objective of exchange rate stability to be pursued, framed by the main objective of price stability. Without this policy it would not be possible to participate in the Euro Zone. The adoption of a target zone has functioned as an important foreign exchange regime of transition to a single currency ‘strategy’. This study also supports the idea that a target zone regime should be considered a feasible solution for ‘tomorrow’ to countries that ‘today’ can be forced to abandon the Euro Zone, since this kind of option combines monetary policy autonomy with macroeconomic stability.

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Bibliographic Info

Paper provided by GEMF - Faculdade de Economia, Universidade de Coimbra in its series GEMF Working Papers with number 2013-03.

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Length: 30 pages
Date of creation: Dec 2012
Date of revision:
Handle: RePEc:gmf:wpaper:2013-03.

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Keywords: ERM; honeymoon effect; STAR model; nonlinearities and target zones.;

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References

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  3. António Portugal Duarte, 2005. "The Portuguese Disinflation Process: Analysis of Some Costs and Benefits," International Finance 0504005, EconWPA.
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  7. António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2010. "Exchange Rate and Interest Rate Distribution and Volatility under the Portuguese Target Zone," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 57(3), pages 261-282, September.
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  22. Lindberg, H. & Soderlind, P., 1991. "Testing the Basic Target Zone Model on Swedish Data," Papers 488, Stockholm - International Economic Studies.
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