Monetary and real shocks and the optimal target zone

An exchange rate target zone is analysed in a model where the economy is disturbed by shocks to money demand and goods demand. The stabilising properties of a target zone are compared to those of fixed and flexible exchange rate regimes. It is found that a target zone offers a compromise between these two extremes. It is also shown that, when there are shocks to both money and goods demand, a target zone is better than either a fixed rate or a floating rate in the sense that it minimises the variance of output and prices.