On the mean-reverting properties of target zone exchange rates: Some evidence from the ERM

Abstract

One key prediction of the target zone model is that the exchange rate should be mean-reverting within the band. Although this property is widely referred to in the target zone literature, little work has been done to test it. In this paper we seek to remedy this important lacuna in the literature by examining the time-series properties of the seven currencies participating in the Exchange Rate Mechanism (ERM) of the European Monetary System, for the period 13 March 1979 to 9 April 1992. Using standard univariate unit root tests we find little evidence of mean reversion. However, using variance ratio test statistics, which control for heterogeneity in the distribution of exchange rate behaviour, we find much more evidence of mean reversion. Another part of our work includes implementing a panel unit-root test.