Target zone models

Question 1

Why is there no such thing as a truly fixed exchange rate

Answer 1

There is no such thing as a truly fixed exchange rate, because most currencies are allowed to float between certain bands in the real world.

Question 2

What is a recent real world example of real world currency bands?

Answer 2

A recent real world example of real world currency bands is the EU currency zone in the European monetary system

Question 3

What do target bands depend on?

Answer 3

Target bands depend on the economic condition and goals of the country.

Question 4

Under the BW system, currencies were allowed to fluctuate by…

Answer 4

Under the Bretton Woods system, currencies were allowed to fluctuate by 1% above or below the specified rate

Question 4

Under the BW system, currencies were allowed to fluctuate by…

Answer 4

Under the Bretton Woods system, currencies were allowed to fluctuate by 1% above or below the specified rate

Question 4

Under the BW system, currencies were allowed to fluctuate by…

Answer 4

Under the Bretton Woods system, currencies were allowed to fluctuate by 1% above or below the specified rate

Question 5

Under the BW system, currencies were allowed to fluctuate by…

Answer 5

Under the Bretton Woods system, currencies were allowed to fluctuate by 1% above or below the specified rate

Question 6

What is a target zone?

Answer 6

A target zone is a specified numerical area within which a currency is allowed to fluctuate

Question 7

What is an example of an expectation caused by a target zone?

Answer 7

An example of an expectation caused by a target zone is that when a currency exchange rate approaches an upper or lower band, there is an expectation that the monetary authority will step in

Question 8

What happens when exchange rates hit the edge of a band?

Answer 8

When exchange rates hit the edge of a band, the currency becomes a fixed exchange rate

Question 8

What happens when exchange rates hit the edge of a band?

Answer 8

When exchange rates hit the edge of a band, the currency becomes a fixed exchange rate

Question 9

If agents are … … then this should affect the behaviour of the exchange rate within the band

Answer 9

If agents are forward thinking, then this should affect the behaviour of the exchange rate within the band

Question 10

What does the monetary authority do to prevent the rate from hitting the top band?

Answer 10

To prevent the rate from hitting the top band, the monetary authority reduces the money supply to cause the exchange rate to appreciate

Question 11

What does the monetary authority do to prevent the rate from hitting the bottom band?

Answer 11

To prevent the rate from hitting the bottom band, the monetary authority increases the money supply to cause the exchange rate to depreciate

Question 12

As long as the exchange rate remains within the …, the money supply will remain …

Answer 12

As long as the rate remains within the band, the money supply will remain unchanged

Question 13

What is marginal intervention?

Answer 13

Marginal intervention is when the monetary authority steps in to prevent the currency from depreciating or appreciating to a level where it reaches a top or bottom band

Question 14

In the presence of exchange rate bands, exchange rate behaviour is described by an … shaped curve

Answer 14

In the presence of exchange rate bands, exchange rate behaviour is described by an S shaped curve

Question 15

Why does the honeymoon effect occur?

Answer 15

The honeymoon effect occurs because as the currency approaches the top or bottom bands, the markets expect the authority to step in, so they will buy or sell the currency accordingly, causing it to restore equilibrium levels without the authority having to actually carry out any action.

Question 16

What are the two assumptions of the basic target zone model?

Answer 16

• The currency bands are completely credible

- Authorities will step in to enforce the bands

Question 17

When tested using real world data, marginal interventions appear to be the … rather than the …

Answer 17

When tested using real world data, marginal interventions appear to be the exception rather than the rule

Question 18

What is the difference in probability of hitting the edge of the band under intramarginal intervention?

Answer 18

Under intermarginal intervention, the probability of hitting the bands is much lower than marginal intervention

Question 19

Why does the curve have an S shape?

Answer 19

The curve has an S shape because as the exchange rate approaches the band, the authorities will step in and intervene, causing the currency to depreciate or appreciate at a slower rate, leaving us with an S shape.