The target zone system is an exchange rate system in which the central bank maintains exchange rates within a specific range. It is similar to a fixed-rate regime, but central banks aim to keep exchange rates in a slightly wider range, giving them more ability to implement discretionary policies.
How the target zone system works
In this system, the central bank allows the exchange rate to float over a specified range (band). It may be broad or narrow.
Furthermore, the target maybe only for a single foreign currency or a basket of selected foreign currencies.
Target bands have upper and lower limits. The central bank tries to intervene in foreign exchange so that it does not come out of those limits.
The width of the band is an essential factor. A wider band makes the exchange rate similar to a floating exchange rate. Meanwhile, the narrower range makes this system similar to the floating but adjustable-rate system.
Advantages and disadvantages
This system prevents the exchange rate from becoming overshooting or irrational movements. In this case, the central bank commitment plays to influence the market in a more positive direction.
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However, the system is also vulnerable to speculative attack. Especially when the central bank commitment is less credible, and the foreign exchange reserve is insufficient to carry out the intervention. Such attacks occurred in Indonesia in 1997, which caused a financial crisis.