This paper by Paul R. Krugman develops a simplified model to analyze exchange rate behavior within a target zone regime. The model demonstrates that the expectation of authorities defending the target zone exerts a stabilizing effect on the exchange rate, even when active intervention is not occurring. The extent of this stabilization is influenced by three factors: the sensitivity of the current exchange rate to expected depreciation, the volatility of the underlying "fundamentals," and the credibility of the authorities' commitment to defend the target zone. The model assumes that the exchange rate is determined by two factors: "fundamentals" (which evolve exogenously) and the expected rate of change of the exchange rate. The actual exchange rate is constrained by a target zone, and the authorities ensure it remains within this zone. Inside the target zone, the actual and shadow exchange rates coincide, leading to an S-shaped relationship between the exchange rate and the fundamentals. This S-shape ensures that fluctuations in fundamentals are less fully reflected in the exchange rate, providing a stabilizing effect. The paper also considers the impact of imperfect credibility, where the market believes the authorities will defend the target zone with probability \(\phi\). In such cases, the stabilizing effect of the target zone is reduced, and the exchange rate behavior becomes more volatile. The main conclusion is that the expectation of authorities defending a target zone leads to more stable exchange rate behavior within the zone, with the extent of stabilization depending on the sensitivity of the exchange rate to expectations, the volatility of fundamentals, and the credibility of the authorities' commitment.This paper by Paul R. Krugman develops a simplified model to analyze exchange rate behavior within a target zone regime. The model demonstrates that the expectation of authorities defending the target zone exerts a stabilizing effect on the exchange rate, even when active intervention is not occurring. The extent of this stabilization is influenced by three factors: the sensitivity of the current exchange rate to expected depreciation, the volatility of the underlying "fundamentals," and the credibility of the authorities' commitment to defend the target zone. The model assumes that the exchange rate is determined by two factors: "fundamentals" (which evolve exogenously) and the expected rate of change of the exchange rate. The actual exchange rate is constrained by a target zone, and the authorities ensure it remains within this zone. Inside the target zone, the actual and shadow exchange rates coincide, leading to an S-shaped relationship between the exchange rate and the fundamentals. This S-shape ensures that fluctuations in fundamentals are less fully reflected in the exchange rate, providing a stabilizing effect. The paper also considers the impact of imperfect credibility, where the market believes the authorities will defend the target zone with probability \(\phi\). In such cases, the stabilizing effect of the target zone is reduced, and the exchange rate behavior becomes more volatile. The main conclusion is that the expectation of authorities defending a target zone leads to more stable exchange rate behavior within the zone, with the extent of stabilization depending on the sensitivity of the exchange rate to expectations, the volatility of fundamentals, and the credibility of the authorities' commitment.