Working Paper: CEPR ID: DP698
Authors: Alan Sutherland
Abstract: Many recent papers suggest that the basic flex-price target zone model does not perform well empirically. This paper derives some of the testable implications of a sticky-price target zone model in order to determine whether the assumption of perfect price flexibility explains the empirical failure of the basic model. I find that while price inertia does introduce mean reversion into the exchange rate, the behaviour of nominal variables is otherwise not qualitatively different from the flex-price model. The paper therefore concludes that the flex-price assumption is not an adequate explanation for empirical failure of the target zone basic model.
Keywords: exchange rates; target zones; price inertia
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| price inertia (D41) | distribution of exchange rates (F31) |
| flex-price model (D43) | exchange rates near edges of target zone (F31) |
| sticky-price model (C54) | exchange rates in center of band when shocks are small (F31) |
| nominal rates (E43) | real rates (E43) |
| sticky-price model (C54) | improvements for real variables (C29) |