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Viera Chmelarova

26 June 2006
WORKING PAPER SERIES - No. 636
Details
Abstract
The target zone model by Krugman (1991) assumes that foreign exchange intervention targets exchange rate levels. We argue that the fit of this model depends on the stage of development of capital markets. Foreign exchange intervention of countries with highly developed capital markets is in line with Krugman's (1991) model as the exchange rate level is targeted (mostly to sustain the competitiveness of exports) and the volatility of day-to-day exchange rate changes are left to market forces. In contrast, countries with underdeveloped capital markets control both volatility of day-to-day exchange rate changes as well as long-term fluctuations of the exchange rate levels to sustain the competitiveness of exports as well as to reduce the risk for short-term and long-term payment flows. Estimations of foreign exchange intervention reaction functions for Japan and Croatia trace the asymmetric pattern of foreign exchange intervention in countries with developed and underdeveloped capital markets.
JEL Code
F31 : International Economics→International Finance→Foreign Exchange