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Exchange rate dynamics in a target zone: a heterogeneous expectations approach

  • Bauer, Christian
  • De Grauwe, Paul
  • Reitz, Stefan

We present a simple behavioral model with chartists and fundamentalists and analyze their trading behavior in a floating regime and in a target zone regime. Regarding the floating regime the model replicates the well-known stylized facts like excessive volatility, fat tails, volatility clustering and the exchange rate disconnect. When introducing a credible target zone the exchange rate remains for a considerably long period in the center of the band albeit the fundamental exchange rate does not exhibit mean reversion tendencies. The resulting hump-shaped distribution of the exchange rate greatly reduces the frequency of central bank intervention. The introduction of a target zone regime significantly reduces exchange rate volatility by decreasing speculative activity in the FX market.

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Paper provided by Deutsche Bundesbank, Research Centre in its series Discussion Paper Series 1: Economic Studies with number 2007,11.

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Date of creation: 2007
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Handle: RePEc:zbw:bubdp1:5864
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