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Can Exchange Rate Dynamics in Krugman¡¯s Target-zone Model be Directly Tested?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

Author

Listed:
  • Cho-Hoi Hui

    (Hong Kong Monetary Authority)

  • Chi-Fai Lo

    (The Chinese University of Hong Kong)

  • Po-Hon Chau

    (The Chinese University of Hong Kong)

Abstract

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  • Cho-Hoi Hui & Chi-Fai Lo & Po-Hon Chau, 2017. "Can Exchange Rate Dynamics in Krugman¡¯s Target-zone Model be Directly Tested?Abstract: Despite Krugman's (1991) model being a benchmark for modelling target zones, empirical support has been sparse d," Working Papers 032017, Hong Kong Institute for Monetary Research.
    • Handle: RePEc:hkm:wpaper:032017
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    • F31 - International Economics - - International Finance - - - Foreign Exchange

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