Target Zones and Interest Rate Variability

Lars Svensson

No 1990/031, IMF Working Papers from International Monetary Fund

Abstract: The trade-off between interest rate variability and the width of an exchange rate target zone is examined, using the regulated Brownian motion model of target zones. The interest rate differential’s asymptotic (unconditional) variability is increasing in the exchange rate band for narrow bands; whereas it is slowly decreasing for wide bands. The interest rate differential’s instantaneous (conditional) variability is decreasing in the exchange rate band. The model is extended to include a realignment/devaluation risk, as well as an endogenous exchange rate risk premium. The risk premium is small for reasonable parameter values.

Keywords: WP; interest rate; risk premium; first derivative; interest rate differential; instantaneous standard deviation; probability mass; responsiveness to the fundamental; exchange rate band; Exchange rates; Managed exchange rates; Return on investment; Crawling peg; Conventional peg (search for similar items in EconPapers)
Pages: 52
Date: 1990-04-01
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Related works:
Journal Article: Target zones and interest rate variability (1991)
Working Paper: Target Zones and Interest Rate Variability (1990)
Working Paper: TARGET ZONES AND INTEREST RATE VARIABILITY (1989)
Working Paper: Target Zones and Interest Rate Variability (1989)
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