A target zone model with the terminal condition of joining a currency area

Abstract

This study aims to generalize the Krugman target zone model for the case of terminal condition of joining a currency area. Using the terminal condition and the ‘smooth pasting conditions’, both analytical and numerical solutions of the problem are obtained. The proposed model is more adequate than the Krugman one when the moment of joining currency area approaches. The properties of the model highlight that monetary authorities have some degree of monetary independence until the moment of entering a currency zone. The model's outcomes are consistent with dynamic properties of the exchange rate time series of the European countries that entered euro zone in January 1999.

Acknowledgments

The views expressed in this article are those of the author and do not necessarily correspond to those of the Bank of Latvia.