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

  • Christian Bauer
  • Paul De Grauwe
  • Stefan Reitz

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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