Economics Letters 71 (2001) 117–129 www.elsevier.com / locate / econbase On the mean-reverting properties of target zone exchange rates: a cautionary note a, b * Mark P. Taylor , Matteo Iannizzotto a Warwick Business School, University of Warwick, Coventry CV47AL, UK b Department of Economics and Finance, University of Durham, 23 –26 Old Elvet, Durham DH13 HY, UK Received 23 March 2000; accepted 15 July 2000 Abstract We estimate a franc–mark target zone model and find a very limited ‘honeymoon effect’. Monte Carlo experiments calibrated with the estimates caution against the use of standard linear tests for non-mean reversion as indirect tests of the target zone model.  2001 Published by Elsevier Science B.V. Keywords: Exchange rates; Target zones; Mean-reversion JEL classification: F31; F33 1. Introduction The purpose of this note is twofold. First, we estimate a target zone exchange rate model of the kind originally suggested by Krugman (1991) and further developed and extended by, inter alios, Froot and Obstfeld (1991) and Flood and Garber (1992); (see Bertola and Caballero, 1992; Svensson, 1992 and Taylor, 1995 for surveys), using daily French franc–German mark data and employing the method of simulated moments estimator. Our parameter estimates, while statistically significant and plausible in magnitude and in line with the literature on estimated elasticities of money demand, imply that the degree of non-linearity in target zone exchange rates – the so-called ‘honeymoon effect’ – is very much smaller than has hitherto been implicitly assumed to be the case. Second, through a battery of Monte Carlo experiments calibrated on our estimated model, we demonstrate that standard tests for non-mean reversion of exchange rates such as Dickey-Fuller or variance ratio tests, may have very little power even when the data is generated by a fully credible target zone arrangement. This cautions *Corresponding author. Tel.: 144-2476-572-832; fax: 144-2476-573-013. E-mail addresses: mark.taylor@wbs.warwick.ac.uk (M.P. Taylor), matteo.iannizzotto@durham.ac.uk (M. Iannizzotto). 0165-1765 / 01 / $ – see front matter  2001 Published by Elsevier Science B.V. PII: S0165-1765(00)00402-X