Playing with the Band: Dynamic Effects of Target Zones in an Open Economy

Abstract

This paper applies techniques of regulated Brownian motion to a model of a small open economy to investigate how bands on fundamental driving variables affect the realization of the nominal exchange rate, the real exchange rate, prices, and output. The author shows that these bands mitigate the relationship between exogenous fundamentals and endogenous variables through their effects on expectations. He also considers the effects of changing the width of the band and finds greater stabilization of endogenous variables with more narrow bands on exogenous fundamentals. Copyright 1990 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

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