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

Author

Listed:
  • 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.

Suggested Citation

  • António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2012. "Testing for Nonlinear Adjustment in the Portuguese Target Zone: Is there a Honeymoon Effect?," GEMF Working Papers 2013-03, GEMF, Faculty of Economics, University of Coimbra.
  • Handle: RePEc:gmf:wpaper:2013-03.
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    References listed on IDEAS

    as
    1. Bernd Kempa & Michael Nelles, 1999. "Misalignments of real exchange rates and the credibility of nominal currency bands," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 135(4), pages 613-628, December.
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    More about this item

    Keywords

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

    JEL classification:

    • 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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