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Target Zones and Exchange Rate Dynamics

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  • Paul R. Krugman

Abstract

This paper develops a highly simplified model of exchange rate behavior within the band under a target zone regime. It shows that the expectation that authorities will defend the band exerts a stabilizing effect on exchange rate behavior within the band, even when the authorities are not actively intervening. The extent of stabilization can be related in a straightforward way to three factors: the sensitivity of the current exchange rate to expected depreciation, the volatility of the process driving exchange rate "fundamentals", and the credibility of the commitment by authorities to defend the target zone.

Suggested Citation

  • Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:2481
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    References listed on IDEAS

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    1. Flood, Robert P & Garber, Peter M, 1983. "A Model of Stochastic Process Switching," Econometrica, Econometric Society, vol. 51(3), pages 537-551, May.
    2. Paul R. Krugman, 1987. "Trigger Strategies and Price Dynamics in Equity and Foreign Exchange Markets," NBER Working Papers 2459, National Bureau of Economic Research, Inc.
    3. Mussa, Michael, 1979. "Empirical regularities in the behavior of exchange rates and theories of the foreign exchange market," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 11(1), pages 9-57, January.
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