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
Date Written: February 28, 2017
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: Suggested Citation