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Probability Analysis of Exchange Rate Target Zones

Author

Listed:
  • Huimin Zhao
  • Fuzhou Gong
  • Fangping Peng
  • Qin Liu

Abstract

The objective of this paper is to show quantitative results for the exchange rate target zones in a small open economy. We develop a stochastic model for exchange rates under the equilibrium in goods and money markets based on a variation of Dornbusch (1976)'s model, incorporating several kinds of macroeconomic shocks and a noneconomic factor ignored by literature. Using the theory of stochastic differential equation (SDE) in probability theory, we calculate the probabilities that the nominal exchange rates reach the boundaries of the target zones for the first time, and the mean time that the nominal exchange rates remain in the target zones. Furthermore, using our explicit expressions of the fundamental factor and the defnite relationships between the variables, we analyze the effects on the probabilities from macroeconomic and non-economic factors, such as the elasticity of the premium rate of exchange rates, the fundamental factor, and the volatilities of the shocks.

Suggested Citation

  • Huimin Zhao & Fuzhou Gong & Fangping Peng & Qin Liu, 2014. "Probability Analysis of Exchange Rate Target Zones," International Journal of Financial Research, International Journal of Financial Research, Sciedu Press, vol. 5(1), pages 29-41, January.
    • Handle: RePEc:jfr:ijfr11:v:5:y:2014:i:1:p:29-41
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    References listed on IDEAS

    as
    1. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    2. Bauer, Christian & De Grauwe, Paul & Reitz, Stefan, 2009. "Exchange rate dynamics in a target zone--A heterogeneous expectations approach," Journal of Economic Dynamics and Control, Elsevier, vol. 33(2), pages 329-344, February.
    3. Ito, Takatoshi & Yabu, Tomoyoshi, 2007. "What prompts Japan to intervene in the Forex market? A new approach to a reaction function," Journal of International Money and Finance, Elsevier, vol. 26(2), pages 193-212, March.
    4. F. De Jong & F. C. Drost & B. J. M. Werker, 2001. "A Jump‐diffusion Model for Exchange Rates in a Target Zone," Statistica Neerlandica, Netherlands Society for Statistics and Operations Research, vol. 55(3), pages 270-300, November.
    5. Beladi, Hamid & Chakrabarti, Avik, 2012. "Stochastic processes and target zones revisited," Economics Letters, Elsevier, vol. 116(1), pages 34-36.
    6. Tronzano, Marco & Psaradakis, Zacharias & Sola, Martin, 2003. "Target zone credibility and economic fundamentals," Economic Modelling, Elsevier, vol. 20(4), pages 791-807, July.
    7. Giuseppe Bertola & Lars E. O. Svensson, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(3), pages 689-712.
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