The optimal degree of exchange rate flexibility: A target zone approach

This paper presents a benchmark model that rationalizes the choice of the degree of exchange rate flexibility. We show that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature on target zones that previous models were not able to generate jointly - namely, the positive relation between the exchange rate and the interest rate differential, the degree of nonlinearity of the function linking the exchange rate to fundamentals, and the shape of the exchange rate stochastic distribution. © 2007 The Authors; Journal compilation © 2007 Blackwell Publishing Ltd.Financial support from the Spanish Ministry of Education and Science and FEDER (SEC2003-0036 and SEC2003-04028/ECO), from the Barcelona Economics Program of XREA, and from CentrA are acknowledged.Peer Reviewe