Optimal Target Zone and Stability Tradeoff

Abstract

Conventional literature on exchange rates largely ignores

normative issues of the target zone regime. This paper builds a

model for the optimal target zone and consider s whether the

target zone is desired compared to other exchange rate regimes.

The paper find s that when the central bank's objective is to

minimize the sum of price and output variances. a target zone

regime is superior to a fixed or floating exchange rate. In

determining the band width, a tradeoff exists between output

and price stability, with a wider band producing smaller output

variability and larger price variability.