Target zones for exchange rates and policy changes

We extend a target zone model to allow for occasional changes in the stochastic process driving fundamentals. A key implication is that seeming speculative attacks may be triggered by market perceptions that macroeconomic policy has switched, say from ‘tight’ to ‘loose’. This fundamental-based explanation for large exchange-rate changes, accompanied by no discernible contemporaneous change in the fundamental, is an alternative to theories based on self-fulfilling expectations. Without relying on intra-marginal intervention, this model is better able to reproduce empirical exchange-rate distributions, with more mass at the center and less at the edges of the band.