Testing for Nonlinear Adjustment in the Portuguese Target Zone: Is there a Honeymoon Effect?

Based on the Krugman (1991) model, the aim of this study is to analyse whether the adoption by Portugal of an exchange rate target zone regime in the context of the participation of the Portuguese escudo in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS), allowed the verification of the existence of a nonlinear S-shaped relationship between the exchange rate and its fundamental determinants. Indeed, it is essential for the Portuguese economy to achieve the conditions of stability, credibility and macroeconomic discipline, since without these it would be very difficult to adopt the European single currency. We tested three models ─ OLS, Auto-correlation by Maximum Likelihood, and GARCH (p, q). We also used LSTAR and ESTAR models to analyse the behaviour of the exchange rate. With this study we also support the idea that a target zone regime should be considered a feasible solution for ‘tomorrow’ for countries that ‘today’ can be forced to abandon the Euro Zone. This kind of option combines monetary policy autonomy with macroeconomic stability.