Exchange Rates Dynamics in a Target Zone - A Heterogeneous Expectations Approach

40 Pages Posted: 15 Aug 2007

See all articles by Christian Bauer

Christian Bauer

University of Trier; Universität Trier

Paul De Grauwe

London School of Economics & Political Science (LSE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)

Stefan Reitz

German Federal Bank - Economics Department

Date Written: August 2007

Abstract

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

Bauer, Christian and De Grauwe, Paul and Reitz, Stefan, Exchange Rates Dynamics in a Target Zone - A Heterogeneous Expectations Approach (August 2007). CESifo Working Paper Series No. 2080, Available at SSRN: https://ssrn.com/abstract=1006985

Christian Bauer

University of Trier ( email )

15, Universitaetsring
Trier, 54286
Germany

Universität Trier ( email )

Germany

Paul De Grauwe (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Stefan Reitz

German Federal Bank - Economics Department ( email )

Wilhelm-Epstein-Str. 14
60431 Frankfurt
Germany

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