Target Zones and Interest Rate VariabilityThe trade-off between interest rate variability and the width of an exchange rate target zone is examined, using the regulated Brownian motion model of target zones. It is shown that for narrow exchange rate bands, and for reasonable parameter values, the interest rate differential's asymptotic variability is increasing in the width of the exchange rate band; whereas for wide exchange rate bands it is slowly decreasing in the exchange rate band. The interest rate differential's instantaneous variability is decreasing in the width of the exchange rate band. A narrow target zone differs from a completely fixed exchange rate regime in that the interest rate differential's instantaneous standard deviation is high and even increases when the zone narrows. The model is extended to include a realignment/devaluation risk, as well as an endogenous exchange rate risk premium. The risk premium is small for reasonable parameter values and does not matter much. |
From inside the book
15 pages matching exchange rate function in this book
Where's the rest of this book?
Results 1-3 of 15
Other editions - View all
Common terms and phrases
CEPR completely fixed exchange constants A₁ curve decreasing derivative devaluation risk differential's instantaneous standard Discussion Papers domestic bonds Dumas ebar ehat endogenous risk premium exchange rate band exchange rate equation exchange rate function exchange rate regime fbar Figure 6b fixed exchange rate float exchange rate Flood and Garber foreign bonds foreign exchange foreign exchange market free float exchange free float rate Froot and Obstfeld function e(ƒ fundamental band GAUSS Dec implies instantaneous standard deviation interest rate differential interest rate differential's interest rate variability Ito's lemma Krugman large band lower and upper LS Aug Monetary money demand money supply narrow target zone negative nominal interest rate Obstfeld 1989a portfolio share rate differential's instantaneous real exchange rate regulated Brownian motion semi-elasticity of money small bands smooth pasting conditions specify std[e std[u stochastic process target zone exchange target zone model upper bounds variance width zero fundamental drift zone exchange rate