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

Christian Bauer (), Paul De Grauwe and Stefan Reitz ()

No 2007,11, Discussion Paper Series 1: Economic Studies from Deutsche Bundesbank, Research Centre

Abstract: 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.

Keywords: Exchange rate; heterogeneous agents; target zones (search for similar items in EconPapers)
JEL-codes: F31 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
Date: Written 2007
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Related works:
Working Paper: Exchange Rates Dynamics in a Target Zone – A Heterogeneous Expectations Approach (2007)
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