The term structure of interest rates in a sticky-price target zone model

The term structure of interest rates in a sticky-price target zone model with perfectly credible marginal central bank intervention is identified by means of an arbitage-free valuation. We fmd that an explicit credible target zone for the exchange rate is associated with an implicit target zone for the long-term interest rate where the nonlinearity of the exchange rate function translates into a corresponding stabilizing nonlinearity of the long-term interest rate. Imposing a target zone reduces the variability of short-term and long-term interest rates and induces a steeper term structure relative to freely floating exchange rates. (C) 1999 Elsevier Science Ltd. All rights reserved.