Nonlinear Exchange Rate Dynamics in Target Zones

This study investigates exchange rate movements in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) and in the Exchange Rate Mechanism II (ERM II). On the basis of the variant of the target zone model proposed by Bartolini and Prati (1999) and Bessec (2003), the authors set up a three-regime self-exciting threshold autoregressive model (SETAR) with a nonstationary central band and explicit modeling of the conditional variance. This modeling framework is employed to model daily Deutsche mark-based and median currency-based bilateral exchange rates of countries participating in the original ERM and also for the exchange rates of the Czech Republic, Hungary, Poland and Slovakia from 1999 to 2004. Our results confirm the presence of strong nonlinearities and asymmetries in the ERM period, which, however, seem to differ across countries and diminish during the last stage of the run-up to the euro. Important nonlinear adjustments are also detected for Denmark in ERM II and for our group of four CEE economies.