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

  • 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)

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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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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  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, vol. 135(4), pages 613-628, December.
  2. Diebold, Francis X. & Nason, James A., 1990. "Nonparametric exchange rate prediction?," Journal of International Economics, Elsevier, vol. 28(3-4), pages 315-332, May.
  3. Chinn, Menzie David, 1991. "Some linear and nonlinear thoughts on exchange rates," Journal of International Money and Finance, Elsevier, vol. 10(2), pages 214-230, June.
  4. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  5. repec:ebl:ecbull:v:6:y:2004:i:8:p:1-19 is not listed on IDEAS
  6. António Portugal Duarte, 2005. "The Portuguese Disinflation Process: Analysis of Some Costs and Benefits," International Finance 0504005, EconWPA.
  7. Richard A. Meese & Andrew K. Rose, 1989. "An empirical assessment of non-linearities in models of exchange rate determination," International Finance Discussion Papers 367, Board of Governors of the Federal Reserve System (U.S.).
  8. Beach, Charles M & MacKinnon, James G, 1978. "A Maximum Likelihood Procedure for Regression with Autocorrelated Errors," Econometrica, Econometric Society, vol. 46(1), pages 51-58, January.
  9. Kenneth A. Froot & Maurice Obstfeld, 1992. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," NBER Working Papers 2835, National Bureau of Economic Research, Inc.
  10. Lindberg, H. & Soderlind, P., 1991. "Testing the Basic Target Zone Model on Swedish Data," Papers 488, Stockholm - International Economic Studies.
  11. António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2010. "Exchange Rate Target Zones: A Survey of the Literature," GEMF Working Papers 2010-14, GEMF - Faculdade de Economia, Universidade de Coimbra.
  12. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, vol. 80(2), pages 192-96, May.
  13. Lindberg, Hans & Soderlind, Paul, 1994. "Testing the basic target zone model on Swedish data 1982-1990," European Economic Review, Elsevier, vol. 38(7), pages 1441-1469, August.
  14. Dick van Dijk & Timo Terasvirta & Philip Hans Franses, 2002. "Smooth Transition Autoregressive Models — A Survey Of Recent Developments," Econometric Reviews, Taylor & Francis Journals, vol. 21(1), pages 1-47.
  15. Anthony, Myrvin & MacDonald, Ronald, 1998. "On the mean-reverting properties of target zone exchange rates: Some evidence from the ERM," European Economic Review, Elsevier, vol. 42(8), pages 1493-1523, September.
  16. repec:cup:cbooks:9780521587822 is not listed on IDEAS
  17. 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.
  18. Dumas, Bernard, 1991. "Super contact and related optimality conditions," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 675-685, October.
  19. Mizrach, B, 1992. "Multivariate Nearest-Neighbor Forecasts of EMS Exchange Rates," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 7(S), pages S151-63, Suppl. De.
  20. Taylor, Mark P. & Peel, David A., 2000. "Nonlinear adjustment, long-run equilibrium and exchange rate fundamentals," Journal of International Money and Finance, Elsevier, vol. 19(1), pages 33-53, February.
  21. Ma, Yue & Kanas, Angelos, 2000. "Testing for nonlinear Granger causality from fundamentals to exchange rates in the ERM," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 10(1), pages 69-82, January.
  22. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
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