exchange rate target zone theory

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The Exchange Rate Target Zone Theory

Exchange rate target zone (ERZT) theory is a theory in international economics that proposes a way of managing exchange rate relationships between major currencies by maintaining a target exchange rate band. The target zone is set to be wider than the actual band of possible exchange rates, which creates a degree of flexibility for the currencies to move within the target zone. ERZT theory is important for understanding how different mechanisms of monetary and fiscal policy can be used to adjust exchange rates.

The target zone enhancement of the international monetary system was first proposed by Robert A. Mundell in the 1980s. According to Mundell, ERZT could help stabilize exchange rates and reduce the volatility of exchange rates in a way that would maximize global economic growth. Mundell argued that a well-defined exchange rate target zone could provide the greatest degree of flexibility for the balance of payments and convertibility adjustment among the major currencies.

The most basic form of ERZT involves two anchor points, which are the upper and lower boundaries of the exchange rate target band. Each anchor point is defined by setting a fixed ratio between two currencies. These fixed ratios are then used to calculate the target exchange rate band, which is a range of exchange rates. The target range is wider than the band of actual exchange rates, making it flexible enough to accommodate varying exchange rate movements.

A target zone could help reduce exchange rate volatility by providing clear expectations of where exchange rates should be and avoid sudden shifts in exchange rates that could cause economic instability. For example, countries could set target zones with each of their major trading partners and agree not to let their exchange rates deviate from the target zone too much. In addition, a target zone could also help countries coordinate their macroeconomic policies better and avoid competing for devaluation of their currencies.

In practice, the efficacy of the ERZT theory is still debated. While some economists agree that a target zone would help alleviate the problem of exchange rate instability, others contend that exchange rates can be more effectively managed through other instruments such as generalised floating rates.

In conclusion, the exchange rate target zone theory is an important contribution to international economics, offering an approach to managing exchange rates that could potentially reduce the risk of exchange rate volatility and therefore contribute to global economic stability.

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Exchange Rate Zones Theory refers to the idea of stabilizing exchange rates by not allowing them to fluctrate more than a previously set percentage or range. This theory suggests that each currency should clearly identify a target zone, or a rate at which it should be trading against other currency. Therefore, in order to reach the target zone, central banks should intervene whenever the currencies fluctrates outside the limits. For example, when a countrys currency is trading below the rate of its target zone, the central bank of that country should buy the currency and vice versa.

This theory was initially proposed by Robert A. Mundell in the late 1960s as an alternative to the existing gold standard system. He proposed a monetary system with several countries participating in it and its main idea was that similar exchange rate would encourage more trade between these countries.

Indeed, Exchange Rate Zone Theory fostered the development of standard economics and greatly facilitated the growth of international trade by eliminating the risk of exchange rate fluctuations. By stabilizing the exchange rates, it allowed countries to deal in other countries currencies on a regular basis. Moreover, it became easier for countries to borrow money in international markets, which in turn helped to finance the development of their economies.

The most notable application of this theory was seen in the formation of European Exchange Rate Mechanism in 1979, which allowed countries in the European Union to maintain fixed exchange rates among each other. This was later replaced by the Euro in 1999.

Although this theory appears attractive in theory, it isnt commonly applied due to its administrative complexities. The implementation of this theory requires constant monitoring, intervention and enforcement of exchange rate limits. Additionally, the lack of credibility of the central banks due to their inconsistency in intervening the exchange rate causes considerable damage to an economy in the long run. Therefore, Exchange Rate Zones Theory can only work efficiently if it is supplemented by other monetary policies.