Exchange rate target zones and the stability of stock market prices

Authors: Chiu-Chiung Huang, Shih-Wen Hu

Journal: Chiao Da Management Review. Jun. 2008, 28(1): 169-203.

Keywords: Exchange rate target zones; Honeymoon effect

Abstract:
Krugman’s target zones theory (1991) is well-known in the economic literature. In a small open-economy model, which includes the commodity, money, bond, and currency exchange markets, he argues that there will be a “honeymoon effect” in the currency exchange market if the government adopts a target zones policy. This study extends his arguments to the stock market and examines whether the target zones policy will lead to the “honeymoon effect” as described by Krugman. We find that the establishment of exchange-rate target zones may not exhibit the “honeymoon e ffect” if the expected exchange-rate fluctuation is smaller than the influence of the expected stock price fluctuation on the exchange rate, no matter whether the shocks originate from the money market or the stock market. The paper also shows that Krugman's conclusion is in fact a special case of our general theory.