Can Exchange Rate Dynamics in Krugman¡¯s Target-zone Model be Directly Tested?Abstract: Despite Krugman's (1991) model being a benchmark for modelling target zones, empirical support has been sparse due to the subtle non-linear relationship between the observable exchange rate and underlying unobservable fundamental. This paper provides an alternative approach to derive explicit exchange rate dynamics by approximating a quadratic relationship between the exchange rate and fundamental through a power-series method. The exchange rate dynamics with a parametric class of drift terms of the stochastic fundamental, including zero-trend (Krugman¡¯s model), symmetric and asymmetric mean-reverting forces regarding how central banks intervene are ready for direct empirical tests. The empirical results demonstrate that the derived dynamics following a square-root process (in Krugman¡¯s model), or mean-reverting square-root process, adequately fit the exchange rate data of various target-zone systems including the Exchange Rate Mechanism and the Linked Exchange Rate System of the Hong Kong dollar. The model parameters of the exchange rate dynamics under the asymmetric mean-reverting fundamental are shown to be associated with realignment of the currencies¡¯ target zones

Hui, Cho-Hoi; Lo, Chi-Fai; Chau, Po-Hon

Can Exchange Rate Dynamics in Krugman¡¯s Target-zone Model be Directly Tested?Abstract: Despite Krugman's (1991) model being a benchmark for modelling target zones, empirical support has been sparse due to the subtle non-linear relationship between the observable exchange rate and underlying unobservable fundamental. This paper provides an alternative approach to derive explicit exchange rate dynamics by approximating a quadratic relationship between the exchange rate and fundamental through a power-series method. The exchange rate dynamics with a parametric class of drift terms of the stochastic fundamental, including zero-trend (Krugman¡¯s model), symmetric and asymmetric mean-reverting forces regarding how central banks intervene are ready for direct empirical tests. The empirical results demonstrate that the derived dynamics following a square-root process (in Krugman¡¯s model), or mean-reverting square-root process, adequately fit the exchange rate data of various target-zone systems including the Exchange Rate Mechanism and the Linked Exchange Rate System of the Hong Kong dollar. The model parameters of the exchange rate dynamics under the asymmetric mean-reverting fundamental are shown to be associated with realignment of the currencies¡¯ target zones

Cho-Hoi Hui, Chi-Fai Lo and Po-Hon Chau
Additional contact information
Cho-Hoi Hui: Hong Kong Monetary Authority
Chi-Fai Lo: The Chinese University of Hong Kong
Po-Hon Chau: The Chinese University of Hong Kong

Working Papers from Hong Kong Institute for Monetary Research

JEL-codes: F31 (search for similar items in EconPapers)
Pages: 38 pages
Date: 2017-02
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