Abstract
Following Krugman (1 99 I), recent models of exchange rates within a target zone have paid particular attention to the effect of the band on exchange rate expectations (see, for example, Miller and Weller, I 989 and Froot and Obstfeld, I 989). The basic idea is that the band, as long as it is credible, has a stabilising effect on the exchange rate not only because the authorities, when necessary, would control the fundamentals in order to contain the movements of the exchange rate, but also because expectations are influenced by the band. These studiesby employing the continuous-time stochastic setting of regulated Brownian motion, familiar from option-pricing theory (cf. Merton, 1973), have also made a significant contribution to the theoretical analysis of the exchange rate. The advantage of the continuous-time framework is that, in a multiperiod setting, it makes the analysis of bands algebraically more manageable than a discrete formulation. To illustrate the approach consider the following simple model from the literature:
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