Target Zones and Interest Rate Variability
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. It is shown that for narrow exchange rate bands, and for reasonable parameter values, the interest rate differential's asymptotic variability is increasing in the width of the exchange rate band; whereas for wide exchange rate bands it is slowly decreasing in the exchange rate band. The interest rate differential's instantaneous variability is decreasing in the width of the exchange rate band.
Published: Journal of International Economics, Vol. 31, pp. 27-54, (1991).