The Optimal Degree of Exchange Rate Flexibility: a Target Zone Approach *

Jesús Rodríguez López and Hugo Rodriguez Mendizabal ()

Review of International Economics, 2007, vol. 15, issue 4, pages 803-822

Abstract: This paper presents a benchmark model that rationalizes the choice of the degree of exchange rate flexibility. We show that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature on target zones that previous models were not able to generate jointly-namely, the positive relation between the exchange rate and the interest rate differential, the degree of nonlinearity of the function linking the exchange rate to fundamentals, and the shape of the exchange rate stochastic distribution. Copyright © 2007 The Authors; Journal compilation © 2007 Blackwell Publishing Ltd.

Date: 2007

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