Exchange Rate Determination and the Collapse of a Target Zone with Stochastic Capital Flows

We develop a model of exchange rate determination for a small open economy under a target zone regime. The driving force of the model is an exogenous stochastic capital flow that is invested in a domestic securities market. Equilibrium exchange rates are the result of equilibrium in both the domestic securities market and a money market. Within the band, interest rates increase as exchange rates depreciate. At the limits of the band the central bank is forced to intervene and can do so through two alternative policies -''sterilization'' and ''non-sterilization''-. Our model allows us to study the effects on interest rates, reserves and exchange rate dynamics of both types of intervention. Furthermore, ''speculative attacks'' arise naturally in our model and seem to mimic the actual dynamics of currency crises. For a given set of parameters, our model allows to predict the sustainability of the regime depending on the type of central bank intervention.