Exchange Rate Target Zones
A target zone attempts to limit the movement of an exchange rate, avoiding the pitfalls of both a pegged rate and a freely floating rate. The European Monetary System was the prime example. An elegant model of Paul Krugman demonstrates that in theory a target zone does indeed stabilize an exchange rate. But in practice it has been substantially rejected empirically. Williamson’s ‘crawling bands’ around a ‘fundamental equilibrium exchange rate’ develop the concept. Target zones survive among candidates for membership of the Eurozone who take part in the Exchange Rate Mechanism mark II.
KeywordsBretton Woods System Brownian motion Capital controls Economic and Monetary Union (EMU) Euro European Monetary System Exchange Rate Mechanism (EU) Exchange rate target zone Fixed exchange rates Floating exchange rates Fundamental equilibrium exchange rate Inflation differentials Monetary theory of the exchange rate Nominal exchange rates Purchasing power parity Real exchange rates Uncovered interest parity Wiener process
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