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Target Zones And Interest Rate Variability

  • SVENSSON, L.E.O.

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 the exchange rate band. 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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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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  1. 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.
  2. Froot, Kenneth A & Obstfeld, Maurice, 1991. "Stochastic Process Switching: Some Simple Solutions," Econometrica, Econometric Society, vol. 59(1), pages 241-50, January.
  3. Miller, M. & Weller, P., 1988. "Exchange Rate Bands And Realignments In A Stationary Stochastic Setting," The Warwick Economics Research Paper Series (TWERPS) 317, University of Warwick, Department of Economics.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. 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.
  9. Smith, Gregor W, 1991. "Solution to a Problem of Stochastic Process Switching," Econometrica, Econometric Society, vol. 59(1), pages 237-39, January.
  10. Jeffrey A. Frankel., 1988. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," Economics Working Papers 8866, University of California at Berkeley.
  11. 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.
  12. Kenneth A. Froot & Maurice Obstfeld, 1992. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," NBER Working Papers 2835, National Bureau of Economic Research, Inc.
  13. 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.
  14. 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.
  15. Dixit, Avinash, 1991. "Analytical Approximations in Models of Hysteresis," Review of Economic Studies, Wiley Blackwell, vol. 58(1), pages 141-51, January.
  16. Paul Krugman & Julio Rotemberg, 1990. "Target Zones with Limited Reserves," NBER Working Papers 3418, National Bureau of Economic Research, Inc.
  17. 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.
  18. Buiter, Willem H. & Grilli, Vittorio, 1989. "The `Gold Standard Paradox' and Its Resolution," CEPR Discussion Papers 361, C.E.P.R. Discussion Papers.
  19. 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.
  20. 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.).
  21. 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.
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