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Exchange Rates Dynamics in a Target Zone – A Heterogeneous Expectations Approach

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  • Christian Bauer
  • Paul De Grauwe
  • Stefan Reitz

Abstract

The target zone model of Krugman (1991) has failed empirically. In this paper, we develop a model of the exchange rate with heterogeneous agents in a free floating and a target zone regime. We show that this simple model mimics the empirical puzzles of exchange rates: excessive volatility, fat tails, volatility clustering, and disconnection from the fundamentals. In addition, the target zone regime replicates a reduced nominal volatility for the same level of fundamental volatility as in the free floating regime and the distribution of the exchange rate within the band is hump-shaped.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 2080.

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Date of creation: 2007
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Handle: RePEc:ces:ceswps:_2080

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Keywords: exchange rate; heterogeneous agents; target zones;

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Citations

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Cited by:
  1. Dick, Christian D. & Menkhoff, Lukas, 2012. "Exchange rate expectations of chartists and fundamentalists," ZEW Discussion Papers 12-026, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  2. Hommes, Cars, 2011. "The heterogeneous expectations hypothesis: Some evidence from the lab," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 35(1), pages 1-24, January.
  3. Dieci, Roberto & Westerhoff, Frank, 2010. "Heterogeneous speculators, endogenous fluctuations and interacting markets: A model of stock prices and exchange rates," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 34(4), pages 743-764, April.
  4. António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2010. "Exchange Rate and Interest Rate Distribution and Volatility under the Portuguese Target Zone," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 57(3), pages 261-282, September.
  5. Barunik, J. & Vosvrda, M., 2009. "Can a stochastic cusp catastrophe model explain stock market crashes?," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 33(10), pages 1824-1836, October.
  6. Reitz, Stefan & Rülke, Jan-Christoph & Stadtmann, Georg, 2012. "Nonlinear expectations in speculative markets – Evidence from the ECB survey of professional forecasters," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 36(9), pages 1349-1363.
  7. António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2010. "Exchange Rate Target Zones: A Survey of the Literature," GEMF Working Papers 2010-14, GEMF - Faculdade de Economia, Universidade de Coimbra.
  8. Grosche, Stephanie & Heckelei, Thomas, 2014. "Price dynamics and financialization effects in corn futures markets with heterogeneous traders," Discussion Papers, University of Bonn, Institute for Food and Resource Economics 172077, University of Bonn, Institute for Food and Resource Economics.
  9. Dieci, Roberto & Westerhoff, Frank, 2009. "A simple model of a speculative housing market," BERG Working Paper Series 62, Bamberg University, Bamberg Economic Research Group.
  10. Lee, Hsiu-Yun, 2011. "Nonlinear exchange rate dynamics under stochastic official intervention," Economic Modelling, Elsevier, Elsevier, vol. 28(4), pages 1510-1518, July.
  11. Miller, J. Isaac, 2011. "Testing the bounds: Empirical behavior of target zone fundamentals," Economic Modelling, Elsevier, Elsevier, vol. 28(4), pages 1782-1792, July.
  12. Antony Jackson & Daniel Ladley, 2013. "Market Ecologies: The Interaction and Profitability of Technical Trading Strategies," Discussion Papers in Economics 13/02, Department of Economics, University of Leicester.
  13. Reitz, Stefan & Rülke, Jan & Stadtmann, Georg, 2012. "Nonlinear Expectations in Speculative Markets," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62045, Verein für Socialpolitik / German Economic Association.

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