A Target-Zone Model with Two Types of Assets

Abstract

This paper extends the single-asset target-zone model pioneered by Krugman (1991) to include both bonds and equities. The new model provides a convenient framework for investigating a ‘puzzle’ recently noted in Hong Kong. While the economy has experienced persistently lower interest rates relative to the US, it has been able to maintain a stable peg between the Hong Kong dollar and the US counterpart under an environment of free capital flows. This is in apparent contradiction with the ‘impossibility trinity’ in the theory of international finance. Our modified analytical structure presents a plausible route to a meaningful answer to the ‘conundrum’ and hopefully yields a certain degree of theoretical generality.

Keywords: Target Zone, Uncovered Interest Rate Parity

JEL Classification: E42, G14