Exchange Rates Dynamics in a Target Zone - A Heterogeneous Expectations Approach
40 Pages Posted: 15 Aug 2007
Date Written: August 2007
The target zone model of Krugman (1991) has failed empirically. In this paper, we develop a model of the exchange rate with heterogeneous agents in a free floating and a target zone regime. We show that this simple model mimics the empirical puzzles of exchange rates: excessive volatility, fat tails, volatility clustering, and disconnection from the fundamentals. In addition, the target zone regime replicates a reduced nominal volatility for the same level of fundamental volatility as in the free floating regime and the distribution of the exchange rate within the band is hump-shaped.
Keywords: exchange rate, heterogeneous agents, target zones
JEL Classification: F31, F41
Suggested Citation: Suggested Citation