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.
A narrow target zone differs from a completely fixed exchange rate regime in that the
interest rate differential's instantaneous standard deviation is high and even increases
when the zone narrows.
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 and does not matter much.
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