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Chapter 10Target-Zone ModelsThis chapter covers a class of exchange rate models where the centralbank of a small open economy is, to varying degrees, committed tokeeping the nominal exchange rate within speciÞed limits commonlyreferred to as the target zone. The target-zone framework is sometimesviewed in a different light from a regime of rigidly Þxed exchange ratesin the sense that many target zone commitments allow for a wider rangeof exchange rate variation around a central parity than is the case inexplicit pegging arrangements. In principle, a target-zone arrangementalso requires less frequent central bank intervention for their maintenance.Our analysis focuses on the behavior of the exchange rate whileit is inside the zone.The target-zone analysis has been used extensively to understandexchange rate behavior for European countries that participated in theExchange Rate Mechanism of the European Monetary System duringthe 1980s where ßuctuation margins ranged anywhere from 2.25 percentto 15 percent about a central parity. The adoption of a commoncurrency makes target-zone analysis less applicable for European issues.However, there remain many developing and newly industrialized countriesin Latin America and Asia that occasionally Þx their exchangerates to the dollar for which the analysis is still relevant. Moreover,there may come a time when the Fed and the European Central Bankwill establish an informal target zone for the dollar—euro exchange rate.Target-zone analysis typically works with the monetary model setin a continuous time stochastic environment. Unless noted otherwise,307