DP698 Target Zone Models with Price Inertia: Some Testable Implications
Many recent papers suggest that the basic flex-price target zone model does not perform well empirically. This paper derives some of the testable implications of a sticky-price target zone model in order to determine whether the assumption of perfect price flexibility explains the empirical failure of the basic model. I find that while price inertia does introduce mean reversion into the exchange rate, the behaviour of nominal variables is otherwise not qualitatively different from the flex-price model. The paper therefore concludes that the flex-price assumption is not an adequate explanation for empirical failure of the target zone basic model.