Abstract
This paper focuses on the interaction between the exchange rate and output in a Mundell–Fleming setup with fixed prices, sluggish output adjustment and permanent equilibria in asset markets. Exchange rate target zones reduce the volatility of exchange rates in the face of an increase in output volatility relative to a free float. An exchange rate target zone offers a degree of flexibility with respect to the incidence of real shocks. Real shocks that push the equilibrium real exchange rate out of the currency band induce speculative runs on currencies and precipitate an abrupt collapse of the target zone.
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