Exchange Rate Target Zones: A Survey of the Literature

This work selectively reviews the literature on exchange rate target zones and their theoretical and empirical methodologies and examines whether they can be used to clarify to what extent this type of exchange rate regime could contribute to greater exchange rate stability. We discuss the main contributions of the first and second generations of exchange rate target zone models. In an attempt to reconcile the poor empirical performance of the Krugman (1991) model with the reality of exchange rate target zone regimes, this line of research integrates target zones with alternative underlying economic models, such as imperfect credibility, intra-marginal interventions and sticky price models. It was thus possible to understand the correlations observed between the exchange rate, its fundamentals determinants and the interest rate differential, and to explain the fact that the statistical distribution of the exchange rate is hump-shaped rather than U-shaped. This implies that the initial emphasis of target zone models on nonlinearities, “honeymoon effect”, “smooth pasting” and marginal interventions has vanished. Exchange rate target zones are better described as similar to managed floating regimes with intra-marginal interventions, with some marginal interventions when the exchange rate reaches the edges of the floating band.Exchange rate target zones, imperfect credibility, intra-marginal interventions realignments and sticky prices.

Exchange Rate Mean Reversion within a Target Zone: Evidence from a Country on the Periphery of the ERM

The aim of this study is to assess to what extent the Portuguese participation in the European Monetary System (EMS) has been characterized by mean reverting behaviour, as predicted by the exchange rate target zone model developed by Krugman (1991). For this purpose, a new class of mean reversion tests is introduced. The empirical analysis of mean reversion in the Portuguese exchange rate shows that most of the traditional unit root and stationarity tests point to the nonstationarity of the exchange rate within the band. However, using a set of variance-ratio tests, it was possible to detect the presence of a martingale difference sequence. This suggests that the Portuguese foreign exchange market has functioned efficiently, allowing us to conclude that the adoption of an exchange rate target zone regime has contributed decisively to the creation of the macroeconomic stability conditions necessary for the participation of Portugal in the euro area.difference sequence, mean reversion, stationarity, target zones and unit roots

Exchange Rate and Interest Rate Distribution and Volatility under the Portuguese Target Zone

The aim of this study is to analyse the exchange rate and interest rate distribution and volatility under the participation of the Portuguese economy in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) based on some of the main predictions of the target zone literature. Portugal adopted this exchange rate target zone from April 6 1992 until December 31 1998. During this period, 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 Paul Krugman (1991) model. The analysis of the data also shows that exchange rate volatility tended to increase as the exchange rate approached the edges of the band, contrary to the predictions of the basic model. Interest rate differential volatility, on the other hand, seemed to behave in line with theoretical predictions. This suggests an increase in the credibility of monetary policy, allowing us to conclude that the adoption of a target zone has contributed decisively to the creation of the macroeconomic stability conditions necessary for the participation in the European Monetary Union (EMU). The Portuguese integration process should therefore be considered as an example to be followed by other small open economies in transition to the euro area.Exchange rate stability, EMS, Volatility and target zones

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

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.Credibility, Exchange rate stability, M-GARCH, ERM, EMS, Volatility and target zones

The Fundamentals of the Portuguese Crisis

This paper analyses the fundamentals of the Portuguese crisis. The financial crisis of 2007 worsened and triggered the current Portuguese crisis. We argue that the main problem that the economy is facing is its output stagnation due to a kind of Dutch disease that has created high and increasing levels of indebtedness, low and decreasing levels of saving and has reduced Portuguese competitiveness. Moreover, the existence of a dualist labour market and a new vague of emigration reproduces inefficiency increasing unemployment of younger workers and the supply of human capital abroad funded by the Portuguese taxpayers. Governance problems such as bad public budget governance, lack of transparency and accountability are also at stake and have to be solved to allow the economy to return to its long-run growth path.Growth, Debt, Saving, Dutch disease, Unemployment, Budget policy.

The Fundamentals of the Portuguese Crisis

This paper analyses the fundamentals of the Portuguese crisis. The financial crisis of 2007 worsened and triggered the current Portuguese crisis. We argue that the main problem the economy is facing is its output stagnation due to a kind of Dutch disease that has created high and increasing levels of indebtedness, low and decreasing levels of saving and has reduced Portuguese competitiveness. Moreover, the existence of a dualist labour market and a new wave of emigration produce inefficiency, increasing unemployment of younger workers and the supply of human capital abroad funded by the Portuguese taxpayers. Governance problems such as poor public budget governance and lack of transparency and accountability are also at stake. These governance problems must be solved to allow the economy to return to its long-run growth path.ntion paid to it than hitherto.Growth, Debt, Saving, Dutch disease, Unemployment, Budget policy

How the gold standard functioned in Portugal: an analysis of some macroeconomic aspects

This paper studies the Gold Standard in Portugal. It was the first country in Europe to join Great Britain in 1854. The principle of free gold convertibility was abandoned in 1891. For the purposes of a macroeconomic study, we also extended the analysis up to 1913. Our study points out the mistake of comparing different systems with the same indicators. Examination of demand, supply and monetary shocks in the context of a VAR model confirm the idea that the principles of classical economics are appropriate for the Gold Standard in Portugal.Gold Standard, Macroeconomic Stability, Convertibility, Portugal, VAR and Unit Roots

How the Gold Standard Functioned in Portugal: An Analysis of Some Macroeconomic Aspects

The purpose of this study is to improve understanding of the gold standard period in Portugal through comparison with other monetary systems that were operated afterwards. Portugal was the first country in Europe to join Great Britain in the gold standard, in 1854, and it adhered to it for quite a long time. The principle of free gold convertibility of the Portuguese currency at a fixed price was abandoned in 1891, even though the classical gold standard as an international monetary system only began to fall apart as a result of the upheavals of the First World War. For the purposes of a macroeconomic study, we can thus first look at the expansion of the functioning of the gold standard in Portugal up to 1913. In addition to a desire to share the same monetary system as its trading and financial partner, the low price of gold and the domestic circulation of British gold coins also played a part, along with other factors, in the adoption of the gold standard in Portugal. While it was in force, it provided a nominal stable anchor and a mechanism of credible commitment, even though Portugal’s monetary authorities broke the “rules of the game”. Our analysis points out the mistake of comparing the stability of different monetary systems with the same indicators. The application of a VAR model enabled us to isolate the period 1854-1891 as being the one that actually corresponds to what we expect of gold standard behaviour. Examination of demand, supply and monetary shocks yields interesting results that confirm the idea that the principles of classical economics are appropriate for the gold standard period.Gold Standard, Macroeconomic Stability, Convertibility, Portugal, VAR, Unit Roots

The Portuguese Public Finances and the Spanish Horse

This study is based on the idea that inadequate use of fiscal policy through restrictive policies shifts the short-run demand curve that in turn induces shifts in the long-run supply curve leading to a dynamic reduction of growth. The analogy with the old metaphor of the Spanish horse seems obvious. We apply this idea to Portugal to 2002-2009, we will prove that in order not to be caught in the horse’s trap we have to keep the concept of potential output in the evaluation of the structural budget balance instead of replacing it by a trend indicator, which, can lead to a sustainable reduction of the “food” and consequently to a disaster. The goal of full employment is no longer present in the idea of zero public balances. In the medium-term, the cycles will offset each other when calculated in relation to a trend and thus the same applies to budget balances as defined in the Stability and Growth Pact (SGP). If actual output moves away persistently from full employment output, trend output will also move away from full employment. As a consequence, expenditures will tend to increase and incomes to decrease. This situation creates deficits that should be corrected by the SGP. This correction will lead to a reduction in demand and thus in actual output and therefore, necessarily, in trend output itself. We present an empirical solution to this problem based on the concept of trend output in order to correct its inflection after 2002. This analysis has two drawbacks, the influence of deficits in the prices of non-tradable goods and the fact that we may not have food to give to our horse. This is the case if public debt is too high. Nevertheless, this study shows that the criteria and methods that are used by the SGP in the definition of fiscal policy are incorrect.Budget deficit, cyclically adjusted budget balance, fiscal policy, Hodrick-Prescott filter and output gap.

Inequality and Growth in Portugal: a time series analysis

Following the recent resurgence of interest on the relationship between inequality and growth and the considerable debate that remains on its sign, we examine this nexus for Portugal during the period 1985–2007 using a time series approach. The results, using different time series methodologies, suggest that earnings inequality has a negative impact on output thus confirming the view that inequality is detrimental to growth. Moreover, according to the results from the impulse response functions based on the preferred trivariate structural VAR model, these effects last in some cases for three years after the inequality shock. As far as education is concerned, the third variable apart from output and inequality considered in our SVAR models, the evidence does not support the theoretical prediction that more inequality reduces human capital accumulation, pointing in fact in the opposite direction: an increase in earnings inequality leads to more educated workers. Thus, the evidence of a negative influence of inequality on output seems to be explained not by the fact that more inequality leads to less human capital accumulation but because it implies more redistribution, with the associated distortionary effects from taxes on investment.output, inequality, education, Hendry-Krolzig methodology, causality, SVAR.