EMPIRICAL FEATURES OF THE SECOND-GENERATION TARGET ZONE MODELS: MEAN-REVERTING FUNDAMENTALS AND ENDOGENOUS DEVALUATION RISK

Authors

  • Klaas H. W. Knot,

    1. Economist, European I Department, International Monetary Fund, 20431 Washington, D.C. Phone 1–202-623-8549, Fax 1–202-623-8832 E-mail Kknot@imf.org
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  • Theo K. Dijkstra,

    1. Associate Professor, Department of Economics, University of Groningen, P.O. Box 800, 9700 AV Groningen, The Netherlands, Phone 31 50 3634532, Fax 31 50 3637337, E-mail t.k.dijkstra@eco.rug.nl
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  • Jakob De Haan

    1. Professor, Department of Economics, University of Groningen, P.O. Box 800, 9700 AV Groningen, The Netherlands, Phone 31 50 3633706 Fax 31 50 3637337, E-mail j.de.haan@eco.rug.nl
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    • *The research underlying the paper was conducted while the first author was at the University of Groningen and at De Nederlandsche Bank (DNB). We owe many thanks to the referee of this journal for his fruitful suggestions and stimulating comments on earlier versions of the paper, and to Jan Egbert Sturm for technical assistance. Any views expressed in the paper are those of the authors and do not necessarily reflect the position of the IMF or DNB.


Abstract

We show that within Bertola and Svensson's second-generation target zone model, mean-reverting interventions and endogenous devaluation risk are closely interrelated. Over the period 1983–93 we analyze the degree of mean reversion in the underlying fundamental process as well as the term structure of interest rate differentials vis-à-vis Germany for six Exchange Rate Mechanism currencies. For Austria, Denmark and the Netherlands, and for Belgium after 1990 our estimates are broadly in line with the first-generation target zone model, whereas those for France and Italy are in accordance with the model that allows for endogenous devaluation risk. (JEL F3 1, E43)

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