Target Zones and Interest Rate Variability

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