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GEMF

Grupo de Estudos Monetários e Financeiros

Estudos do GEMF, N.º 03 de 2008

  

Exchange Rate and Interest Rate Volatility in a Target Zone: The Portuguese Case


António Portugal Duarte
GEMF and Faculdade de Economia, Universidade de Coimbra

João Sousa Andrade

GEMF and Faculty of Economics, University of Coimbra

Adelaide Duarte

GEMF and Faculty of Economics, University of Coimbra

Abstract:
This work examines the participation of the Portuguese economy in the ERM of the EMS based on some of the main predictions of the target zone literature. 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 Krugman (1991) model. Using a M-GARCH model however we confirm that there is a trade-off between exchange rate volatility and interest rates differential volatility. These results express the increased credibility of the Portuguese monetary policy, due manly to the modernisation of the banking and financial system and to the progress made in terms of the disinflation process under an exchange rate target zone policy. In accordance to these results we can say that the participation of the Portuguese escudo in an exchange rate target zone was crucial to create the conditions of stability, credibility and confidence necessary for the adoption of a single currency.

JEL Classification: C32, C51, F31, F41, G15.

Keywords:
Credibility, exchange rate stability, M-GARCH, ERM, EMS, volatility and target zones.

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