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

António Portugal Duarte (), João Sousa Andrade () and Adelaide Duarte ()
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Adelaide Duarte: GEMF and Faculty of Economics of the University of Coimbra
Authors registered in the RePEc Author Service: Maria Adelaide Silva Duarte ()

No 2008-03, GEMF Working Papers from GEMF - Faculdade de Economia, Universidade de Coimbra

Abstract: 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.

Keywords: Credibility; Exchange rate stability; M-GARCH; ERM; EMS; Volatility and target zones (search for similar items in EconPapers)
JEL-codes: C32 C51 F31 F41 G15 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mon and nep-opm
Date: Written
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Persistent link: http://EconPapers.repec.org/RePEc:gmf:wpaper:2008-03

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