Target Zones and Exchange Rate Dynamics

Paul R. Krugman

The Quarterly Journal of Economics, 1991, vol. 106, issue 3, 669-682

Abstract: This paper develops a simple model of exchange rate behavior under a target zone regime. It shows that the expectation that monetary policy will be adjusted to limit exchange rate variation affects exchange rate behavior even when the exchange rate lies inside the zone and is thus not being defended actively. Somewhat surprisingly, the analysis of target zones turns out to have a strong formal similarity to problems in option pricing and investment under uncertainty.

Date: 1991
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