This paper sets up a modified Mundell-type economy embodying a New Keynesian “forward-looking” exchange-rate and output expectations, and develops a graphical exposition to explain the conflicting outcome between Krugman's (1991) prediction and the empirical observations in the regime of...

The volatility trade-offs (i.e. the negative relationships between exchange rate variability and the interest rate differential) exhibited in the Krugman [Krugman, P. (1991). Target zones and exchange rate dynamics. Quarterly Journal of Economics, 106, 669-682.] model depend on the assumption of...