A target zone arrangement is an agreed exchange rate system in which certain countries pledge to maintain their currency exchange rate within a specific fluctuation margin or band. This margins can be set vis-à-vis another currency, a cooperative arrangement (such as the ERMII), or a basket of currencies. The spread of this margin can however vary, giving way to two different versions:
Strong version: also known as conventional fixed peg arrangements. The exchange rate, fluctuates within margins of ±1% or less, and is revised quite infrequently. The monetary authority can maintain the exchange rate within margins through direct intervention (for instance, purchasing and selling domestic and foreign currency in the market) or through indirect intervention (for instance influencing on interest rates). The flexibility of monetary policy is larger than for exchange arrangements with no separate legal tender.
Weak version: also known as pegged exchange rates within horizontal bands. In this case, the exchange rate fluctuates more than ±1% around the fixed central rate. Here, there is a limited degree of monetary policy discretion.
Target zone arrangements can be seen as being half way between fixed and flexible exchange rates. This kind of exchange rate system therefore allows for relatively stable trading conditions to prevail between countries, and at the same time allows some fluctuation in foreign exchange rates depending on relative economic conditions and trade flows.
The following figure shows the different exchange rate regimes according to four different variables: exchange rate flexibility, loss of monetary policy independence, anti-inflation effect and credibility of the exchange rate commitment:
