Optimal target zone and stability tradeoff

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 considers whether the target zone is desired compared to other exchange rate regimes. The paper finds 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.