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 constant-trend, 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 mean-reverting square-root or double square-root processes adequately fits the exchange rate data of various target-zone systems including the Exchange Rate Mechanism. 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.
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