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Exchange Rate and Interest Rate Volatility in a Target Zone: The Portuguese Case

  • António Portugal Duarte

    ()

    (GEMF and Faculdade de Economia, Universidade de Coimbra)

  • João Sousa Andrade

    ()

    (GEMF and Faculty of Economics of the University of Coimbra)

  • Adelaide Duarte

    ()

    (GEMF and Faculty of Economics of the University of Coimbra)

This work examines the participation of the Portuguese economy in the ERM of the EMS based on some of the main predictions of the target zone literature. The exchange rate distribution reveals that the majority of the observations lie close to the central parity, thus rejecting one of the key predictions of the Krugman (1991) model. Using a M-GARCH model however we confirm that there is a trade-off between exchange rate volatility and interest rates differential volatility. These results express the increased credibility of the Portuguese monetary policy, due manly to the modernisation of the banking and financial system and to the progress made in terms of the disinflation process under an exchange rate target zone policy. In accordance to these results we can say that the participation of the Portuguese escudo in an exchange rate target zone was crucial to create the conditions of stability, credibility and confidence necessary for the adoption of a single currency.

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File URL: http://gemf.fe.uc.pt/workingpapers/pdf/2008/gemf_2008-03.pdf
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Paper provided by GEMF - Faculdade de Economia, Universidade de Coimbra in its series GEMF Working Papers with number 2008-03.

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Length: 38 pages
Date of creation: 2008
Date of revision:
Handle: RePEc:gmf:wpaper:2008-03
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