The Theory of Exchange Rate Target Zones

Bernd Kempa and Michael Nelles

Journal of Economic Surveys, 1999, vol. 13, issue 2, 173-210

Abstract: The theory of exchange rate target zones focuses on the role of exchange rate expectations in determining exchange rate behaviour and interest rate differentials in currency bands. This paper analyses earlier models of the target zone research programme as well as more recent developments including endogenous realignment expectations, price rigidities and alternative monetary feedback rules by means of a unified approach. Target zones may be the cause of stabilizing or destabilizing exchange rate expectations, the determinants of which crucially depend on the within‐band central bank policy as well as the credibility of the central banks’ commitment to defend the target zone. The paper closes with a discussion of the relative merits of implementing a target zone and some suggestions for further research.

Date: 1999
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