Krugman (1991) provided a rigorous economic argument for the merits of target zone exchange rate arrangements. His analysis revealed the existence of a stabilizing nonlinear relation between the exchange rate and its driving fundamentals. However, the econometric testing of this relationship has proved difficult. We use data from the European Monetary System (EMS) to implement efficient testing of the Krugman model and extensions which allow mean reversion in the fundamentals process. In particular, we model the fundamentals driving the bilateral exchange rates of participating currencies by means of an Ornstein Uhlenbeck process with reflecting barriers. This specification captures the enforcement of an exchange rate fluctuation band through central bank intervention at band limits as well as through intramarginal intervention. Our empirical work is based on a period of exceptional stability in exchange rate markets and well approximates the credible band limit assumptions common in the target zone modelling literature. Building on recent work by Ricciardi and Sacerdote (1987), de Jong (1991), and Lindberg and Söderlind (1991, 1992), we implement full maximum likelihood estimation of the parameters of the time series dynamics for the most heavily traded bilateral exchange rates in the EMS. In doing so we identify the functional relation between the fundamentals and the exchange rate and quantify the nonlinearity in this relation. When nonlinearity is not present, a restriction of the model posits that the exchange rate, per se, follows a reflected OU process. A further restriction contains reflected Brownian motion as a nested special case. Our analysis affords a description of the alternative exchange rate policies adopted in the various countries party to the EMS. © 1994.

Ball, C.A., Roma, A. (1994). Target zone modelling and estimation for European Monetary System exchange rates. JOURNAL OF EMPIRICAL FINANCE, 1(3-4), 385-420 [10.1016/0927-5398(94)90010-8].

Target zone modelling and estimation for European Monetary System exchange rates

Roma A.
1994-01-01

Abstract

Krugman (1991) provided a rigorous economic argument for the merits of target zone exchange rate arrangements. His analysis revealed the existence of a stabilizing nonlinear relation between the exchange rate and its driving fundamentals. However, the econometric testing of this relationship has proved difficult. We use data from the European Monetary System (EMS) to implement efficient testing of the Krugman model and extensions which allow mean reversion in the fundamentals process. In particular, we model the fundamentals driving the bilateral exchange rates of participating currencies by means of an Ornstein Uhlenbeck process with reflecting barriers. This specification captures the enforcement of an exchange rate fluctuation band through central bank intervention at band limits as well as through intramarginal intervention. Our empirical work is based on a period of exceptional stability in exchange rate markets and well approximates the credible band limit assumptions common in the target zone modelling literature. Building on recent work by Ricciardi and Sacerdote (1987), de Jong (1991), and Lindberg and Söderlind (1991, 1992), we implement full maximum likelihood estimation of the parameters of the time series dynamics for the most heavily traded bilateral exchange rates in the EMS. In doing so we identify the functional relation between the fundamentals and the exchange rate and quantify the nonlinearity in this relation. When nonlinearity is not present, a restriction of the model posits that the exchange rate, per se, follows a reflected OU process. A further restriction contains reflected Brownian motion as a nested special case. Our analysis affords a description of the alternative exchange rate policies adopted in the various countries party to the EMS. © 1994.
1994
Ball, C.A., Roma, A. (1994). Target zone modelling and estimation for European Monetary System exchange rates. JOURNAL OF EMPIRICAL FINANCE, 1(3-4), 385-420 [10.1016/0927-5398(94)90010-8].
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11365/1130617