Target zones are agreements in which two or more countries agree to keep the exchange rate between their currencies within a certain range. That is, it points to exchange rate stability.
In other words, target zones are treaties that allow a pair (or group) of currencies to be traded at a price that will hold without much variability.
This type of system is not as rigid as the fixed exchange rate. However, it requires a greater commitment on the part of the monetary authorities compared to the flexible exchange rate.
Characteristics of the target areas
The characteristics of the target areas include:
- It allows offering greater certainty to economic agents. In other words, exchange rate risk is reduced, so that exporters and importers can estimate the results of their businesses with a greater margin of safety.
- Given the previous point, the target zones allow to encourage trade between the participating nations.
- The agreements can be subject to different degrees of flexibility, being able to admit variations, for example, of 1% or 3% above and below an exchange rate level.
- To keep the exchange rate within the target range, the monetary authority intervenes. This, through its different instruments, such as the direct purchase or sale of currency or repos.
Example of target zones
An example of target areas can be the one applied in the European Union (EU) through the Exchange Rate Mechanism (ERM). This offers a framework to manage the price of the euro in relation to the currency of a country that does not belong to the euro zone, but does belong to the European Community.
Currently, the ERM only includes the currency of Denmark. Thus, the Danish krone joined ERM II on January 1, 1999, committing to maintain an exchange rate of 7.46038 kroner per euro. This, with a narrow fluctuation band of ± 2.25%.