Can one hear the shape of a target zone?

DOI10.1016/J.JMATECO.2023.102852MaRDI QIDQ6170032zbMATH OpenOpenAlexFDO

Authors Jean-Louis Arcand, Shekhar Hari Kumar, Max-Olivier Hongler, Daniele Rinaldo

Publication date 15 August 2023

Published in Journal of Mathematical Economics (Search for Journal in Brave)

Copyright license Creative Commons Attribution 4.0 International

Full work available at URL https://arxiv.org/abs/2002.00948

zbMATH Keywords

dynamic mean-preserving spreadsexchange rate target zonesnon-stationary exchange rate dynamicsreflected stochastic differential equationsregime shiftsspectral gap

Mathematics Subject Classification ID

Macroeconomic theory (monetary models, models of taxation) (91B64)

Abstract: We develop an exchange rate target zone model with finite exit time and non-Gaussian tails. We show how the tails are a consequence of time-varying investor risk aversion, which generates mean-preserving spreads in the fundamental distribution. We solve explicitly for stationary and non-stationary exchange rate paths, and show how both depend continuously on the distance to the exit time and the target zone bands. This enables us to show how central bank intervention is endogenous to both the distance of the fundamental to the band and the underlying risk. We discuss how the feasibility of the target zone is shaped by the set horizon and the degree of underlying risk, and we determine a minimum time at which the required parity can be reached. We prove that increases in risk after a certain threshold can yield endogenous regime shifts where the ``honeymoon effects vanish and the target zone cannot be feasibly maintained. None of these results can be obtained by means of the standard Gaussian or affine models. Numerical simulations allow us to recover all the exchange rate densities established in the target zone literature. The generality of our framework has important policy implications for modern target zone arrangements.

Recommendations

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Cites work

• A symmetrized Euler scheme for an efficient approximation of reflected diffusions
• A time series model for an exchange rate in a target zone with applications
• Can One Hear the Shape of a Drum?
• Exchange Rate Dynamics in a Multilateral Target Zone
• Increasing risk: dynamic mean-preserving spreads
• On the transition densities for reflected diffusions
• Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models
• Stochastic simulation: Algorithms and analysis
• Variable Probability of Realignment in a Target Zone

Cited in

(26)

• An analytical approximation of target zone exchange rate functions: the technique of collocation
• The scope for monetary independence in exchange rate target zones broad and narrow
• Interest rate, speculative attacks and target zones
• Narrow target zones within broad zones: A non-speculative exchange rate solution with limited resources
• Target zones and small realignments
• An heterogeneous expectations target zone model
• Exchange rate dynamics in a target zone-A heterogeneous expectations approach
• Can one hear whistler waves?
• Limited reserves and the optimal width of an exchange rate target zone
• The revival of target zone modeling
• Can one hear the shape of a network?
• The valuation of options on foreign exchange rate in a target zone
• A time series model for an exchange rate in a target zone with applications
• Intervention Policy and Mean Reversion in Exchange Rate Target Zones: The Swedish Case
• Variable Probability of Realignment in a Target Zone
• Estimating Expected Exchange Rates Under Target Zone Regimes
• scientific article; zbMATH DE number 1327258 (Why is no real title available?)
• Intramarginal Interventions, Bands and the Pattern of EMS Exchange Rate Distributions
• A Jump‐diffusion Model for Exchange Rates in a Target Zone
• Exchange Rate Dynamics in a Multilateral Target Zone
• On the sustainability of exchange rate target zones with central parity realignments
• A model of inflation transmission in an exchange rate target zone
• The Danish krone-euro exchange rate and Danmark Nationalbank intervention operations
• On the mean-reverting properties of target zone exchange rates: A cautionary note
• Optimal target zones
• Target zone interventions and coordination of expectations

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