Target Zones and Interest Rate Variability

Author/Editor:

Lars E. O. Svensson

Publication Date:

April 1, 1990

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

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. The interest rate differential’s asymptotic (unconditional) variability is increasing in the exchange rate band for narrow bands; whereas it is slowly decreasing for wide bands. The interest rate differential’s instantaneous (conditional) variability is decreasing in the exchange rate band. 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.

Series:

Working Paper No. 90/31

English

Publication Date:

April 1, 1990

ISBN/ISSN:

9781451979992/1018-5941

Stock No:

WPIEA0311990

Format:

Paper

Pages:

52

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