Toward an econometric target zone model with endogenous devaluation risk for a small open economy

Abstract

A number of econometric target zone models is estimated for the Belgian franc and the Dutch guilder vis-à-vis the deutsche mark, with a particular focus on the modeling of endogenous devaluation risk. Both currencies can be characterized by mean reversion, whereas the theoretical S-effect is observed only for the Belgian franc. Exchange rate volatility can be adequately modeled by means of a GARCH(1,1) process. For the Belgian franc, exchange rate tensions have been induced by movements in the inflation differential vis-à-vis Germany and the level of foreign exchange reserves, whereas for the Dutch guilder the interest rate differential vis-à-vis Germany and the level of foreign exchange reserves have been particularly important.