The Revival of Target Zone Modeling

Krugman's ‘honeymoon’ seminal paper showed in 1991 the stabilizing properties of the adoption of floating bands and gave rise to the literature on target zones. Subsequent contributions, however, showed that, in the absence of adequate reserve, a destabilizing 'divorce' would lead to speculative attacks. The euro area public debt crisis revived that literature, producing a second generation of target zone modeling, based on the idea that the sustainability of public debt implies the adoption of an interest rate target. Its lack of credibility (if the central bank or the government does not guarantee repayment of the debt) explains the non-linearity of interest rates that was observed during the euro area crisis. The model also allows to understand why some non-euro area countries were not subject to speculative attacks despite the fact that their public debt-to-GDP ratios were as high as those of countries in crisis, but guaranteed by the "virtual" reserves of their national central banks. Finally, a third generation of target zone modeling could also be identified with its application to the current crisis of economic globalization and has been extended to merge it with heterogeneous agents modeling.