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Target zone (exchange rates)
3 key takeaways
Copy link to section- A target zone stabilizes exchange rates within a specified range around a central value, preventing excessive volatility.
- Governments or central banks intervene in foreign exchange markets to keep the currency within the target zone.
- Understanding target zones helps in analyzing how countries manage exchange rates to balance trade competitiveness and economic stability.
What is a target zone (exchange rates)?
Copy link to sectionA target zone in exchange rates is a type of exchange rate regime where a currency’s value is allowed to fluctuate within a defined band around a central or target exchange rate. The target zone aims to combine the stability of fixed exchange rates with the flexibility of floating rates. When the exchange rate approaches the boundaries of the band, the central bank intervenes in the foreign exchange market to prevent the currency from moving outside the specified range.
The primary purpose of a target zone is to reduce exchange rate volatility, which can create uncertainty in international trade and investment. By maintaining the exchange rate within a target zone, countries can provide a more predictable economic environment while allowing some degree of flexibility in response to market conditions.
How does a target zone work?
Copy link to section- Setting the central rate and bands: The central rate is the target exchange rate around which the currency is allowed to fluctuate. The bands are the upper and lower limits within which the exchange rate must stay. For example, if the central rate is set at $1.00 per currency unit with a band of ±2%, the exchange rate can fluctuate between $0.98 and $1.02.
- Market intervention: When the exchange rate approaches the upper or lower limit of the band, the central bank intervenes by buying or selling its currency to maintain the exchange rate within the target zone. This intervention helps stabilize the exchange rate and prevent it from breaching the band.
- Adjustment mechanisms: If persistent market pressures push the exchange rate toward the limits of the band, the central rate or the width of the bands may be adjusted to reflect changes in economic fundamentals.
Examples of target zones
Copy link to section- European Exchange Rate Mechanism (ERM): Before the introduction of the euro, the ERM was a system where European Union member countries maintained their exchange rates within a target zone around a central parity. The ERM aimed to stabilize exchange rates and prepare countries for the adoption of a single currency.
- Swedish Krona: In the early 1990s, Sweden used a target zone for the Swedish krona, maintaining its value within a band around a central rate against a basket of currencies. The target zone provided exchange rate stability while allowing some flexibility.
Understanding target zones in exchange rates is crucial for analyzing how countries manage their currencies to balance trade competitiveness and economic stability. It also provides insights into the tools and strategies used by central banks to intervene in foreign exchange markets. For further exploration, consider studying historical examples of target zones, their successes and challenges, and the role of international cooperation in maintaining these regimes.
More definitions
Sources & references

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