of the main implications of the basic target zone model developed by Krugman
(1991) is that there is a trade-off between exchange rate volatility
and interest rate differential volatility. Using an M-GARCH model we find
evidence that such a trade-off existed, prior to the introduction of the euro, between the
exchange rate and the interest rate differential
among Portugal and Germany. This result reflects the increased credibility of the Portuguese
monetary policy, due mainly to the modernisation of the banking and financial
system and to the progress made in the disinflation process under an exchange
rate target zone.
JEL Classification: C32, C51, F31, F41, G15.
Keywords: Credibility, disinflation, M-GARCH,
volatility and target zones.