The target zone model, non-linearity and mean reversion: Is the honeymoon really over?

We estimate a target zone model for three ERM exchange rates for 1983-6 and 1987-91 by the method of simulated moments, taking account of the continuo us time specification by using daily data with the interruptions of holiday s and weekends. Specification tests are unable to reject the model. The est imates imply, however, an essentially linear relationship between the excha nge rate and the fundamentals, with a very limited 'honeymoon effect'. Usin g Monte Carlo simulations, calibrated on the estimates, we find that standa rd tests for mean reversion of the exchange rate would largely reject the t arget zone model when, in fact, it held.