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Target Zones And Interest Rate Variability

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  • SVENSSON, L.E.O.

Abstract

The 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 this width. 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.

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Bibliographic Info

Paper provided by Stockholm - International Economic Studies in its series Papers with number 457.

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Length: 34 pages
Date of creation: 1989
Date of revision:
Handle: RePEc:fth:stocin:457

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Keywords: interest rate ; exchange rate ; economic models ; risk;

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References

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  1. Froot, Kenneth & Obstfeld, Maurice, 1991. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," CEPR Discussion Papers 522, C.E.P.R. Discussion Papers.
  2. Paul Krugman & Julio Rotemberg, 1990. "Target Zones with Limited Reserves," NBER Working Papers 3418, National Bureau of Economic Research, Inc.
  3. Miller, Marcus & Weller, Paul, 1989. "Exchange Rate Bands and Realignments in a Stationary Stochastic Setting," CEPR Discussion Papers 299, C.E.P.R. Discussion Papers.
  4. Miller, Marcus & Weller, Paul, 1989. "Solving Stochastic Saddlepoint Systems: A Qualitative Treatment with Economic Applications," CEPR Discussion Papers 308, C.E.P.R. Discussion Papers.
  5. Michael P. Dooley & Peter Isard, 1979. "The portfolio-balance model of exchange rates," International Finance Discussion Papers 141, Board of Governors of the Federal Reserve System (U.S.).
  6. Lars Hörngren & Anders Vredin, 1989. "Exchange risk premia in a currency basket system," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 125(2), pages 311-325, June.
  7. Bernard Dumas, . "Super Contact and Related Optimality Conditions: A Supplement to Avinash Dixit's: "A Simplified Exposition of Some Results Concerning Regulated Brownian Motion" (Reprint 020)," Rodney L. White Center for Financial Research Working Papers 43-88, Wharton School Rodney L. White Center for Financial Research.
  8. Klein, Michael W., 1992. "Big effects of small interventions: The informational role of intervention in exchange rate policy," European Economic Review, Elsevier, vol. 36(4), pages 915-924, May.
  9. Frankel, Jeffrey A., 1986. "The implications of mean-variance optimization for four questions in international macroeconomics," Journal of International Money and Finance, Elsevier, vol. 5(1, Supple), pages S53-S75, March.
  10. Jeffrey A. Frankel, 1987. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," NBER Working Papers 2367, National Bureau of Economic Research, Inc.
  11. Willem H. Buiter & Vittorio U. Grilli, 1989. "The "Gold Standard Paradox" and its Resolution," NBER Working Papers 3178, National Bureau of Economic Research, Inc.
  12. Bernard Dumas, . "Pricing Physical Assets Internationally: A Non Linear Heteroskedastic Process for Equilibrium Real Exchange Rates," Rodney L. White Center for Financial Research Working Papers 25-89, Wharton School Rodney L. White Center for Financial Research.
  13. Robert P. Flood & Peter M. Garber, 1989. "The Linkage Between Speculative Attack and Target Zone Models of Exchange Rates," NBER Working Papers 2918, National Bureau of Economic Research, Inc.
  14. Frankel, Jeffrey A., 1988. "Recent Estimates of the Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Department of Economics, Working Paper Series qt23c9q73d, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  15. Dixit, Avinash, 1991. "A simplified treatment of the theory of optimal regulation of Brownian motion," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 657-673, October.
  16. Dixit, Avinash, 1991. "Analytical Approximations in Models of Hysteresis," Review of Economic Studies, Wiley Blackwell, vol. 58(1), pages 141-51, January.
  17. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
  18. Bernard Dumas, . "Perishable Investment and Hysteresis in Capital Formation," Rodney L. White Center for Financial Research Working Papers 44-88, Wharton School Rodney L. White Center for Financial Research.
  19. Smith, Gregor W, 1991. "Solution to a Problem of Stochastic Process Switching," Econometrica, Econometric Society, vol. 59(1), pages 237-39, January.
  20. Klein, Michael W, 1990. "Playing with the Band: Dynamic Effects of Target Zones in an Open Economy," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 31(4), pages 757-72, November.
  21. Kenneth A. Froot & Maurice Obstfeld, 1989. "Stochastic Process Switching: Some Simple Solutions," NBER Working Papers 2998, National Bureau of Economic Research, Inc.
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