Exchange rate and interest rate distribution and volatility under the Portuguese target zone

Duarte Portugal,Adelaide Duarte,Sousa Andrade

doi:10.2298/pan1003261p

Abstract

The aim of this study is to analyse the exchange rate and interest rate distribution and volatility under the participation of the Portuguese economy in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) based on some of the main predictions of the target zone literature. Portugal adopted this exchange rate target zone from April 6 1992 until December 31 1998. During this period, 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 Paul Krugman (1991) model. The analysis of the data also shows that exchange rate volatility tended to increase as the exchange rate approached the edges of the band, contrary to the predictions of the basic model. Interest rate differential volatility, on the other hand, seemed to behave in line with theoretical predictions. This suggests an increase in the credibility of monetary policy, allowing us to conclude that the adoption of a target zone has contributed decisively to the creation of the macroeconomic stability conditions necessary for the participation in the European Monetary Union (EMU). The Portuguese integration process should therefore be considered as an example to be followed by other small open economies in transition to the euro area.

Highlights

In this study we have analysed the participation of the Portuguese escudo in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) according to the literature on target zones
The contribution to the literature stems from the fact that we considered a currency from the system’s periphery, while most previous work has focused on the Nordic countries and on fluctuation bands of the ERM considered as more stable and credible
The empirical results do not support the theoretical predictions of the basic target zone model, but this does not mean that the participation in a target zone did not have a stabilizing effect upon the exchange rate behaviour

Summary

The Portuguese Exchange Rate Target Zone

On April 6 1992, the framework of the Portuguese monetary and foreign exchange policy changed when the Portuguese escudo joined the ERM of the EMS. As there was a formal commitment to keep the Portuguese escudo within the band from this date, the credibility of the disinflation policy increased, facilitating the pursuit of the price stability goal This foreign exchange policy course was maintained until the end of 1998, in spite of the disturbances that affected the EMS. This was the result of the pegging of the Portuguese escudo to the Deutschmark, which allowed the Portuguese currency to benefit from the credibility, stability and discipline associated with the tacit acceptance of the antiinflationary stance of the Bundesbank’s monetary policy. Concentrating on the target zone period, it is possible to confirm that after joining the ERM, the Portuguese escudo registered a significant nominal appreciation and an almost immediate decline to a value near the lower edge of its band. On a continuous decline in the inflation rate which coincided with the participation of the Portuguese escudo in the exchange rate target zone

Distribution and Volatility under an Exchange Rate Target Zone

Data Description

Empirical Analysis under the Portuguese Target Zone

Findings

Conclusion