Working Paper: CEPR ID: DP372
Authors: Lars E. O. Svensson
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. 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 this width. 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.
Keywords: target zones; interest rate variability; risk premium; regulated brownian motion
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| narrowing exchange rate target zone (F31) | increased interest rate differential variability (E43) |
| increased width of exchange rate band (F31) | greater interest rate differentials' asymptotic variability (E43) |
| increased width of exchange rate band (F31) | decreased instantaneous variability of interest rate differentials (E43) |
| narrow target zone (E63) | higher instantaneous standard deviations of interest rate differentials (E43) |