Can Exchange Rate Dynamics in Krugman's Target-Zone Model Be Directly Tested?

HKIMR Working Paper No. 03/2017

38 Pages Posted: 1 Mar 2017

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

Po-Hon Chau

The Chinese University of Hong Kong (CUHK)

Multiple version iconThere are 2 versions of this paper

Date Written: February 28, 2017

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 zero-trend (Krugman’s model), 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 square-root process (in Krugman’s model), or mean-reverting square-root process, adequately fit the exchange rate data of various target-zone systems including the Exchange Rate Mechanism and the Linked Exchange Rate System of the Hong Kong dollar. 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.

Keywords: Exchange Rate Dynamics, Target Zones, Interventions, Stochastic Processes

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Chau, Po-Hon, Can Exchange Rate Dynamics in Krugman's Target-Zone Model Be Directly Tested? (February 28, 2017). HKIMR Working Paper No. 03/2017. Available at SSRN: https://ssrn.com/abstract=2925040 or http://dx.doi.org/10.2139/ssrn.2925040

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Po-Hon Chau

The Chinese University of Hong Kong (CUHK) ( email )

Shatin, N.T.
Hong Kong
Hong Kong

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