Exchange-Rate Band

An exchange-rate band is a range of values around a central rate within which a country's currency is allowed to trade. Inside the band, the exchange rate is set by supply and demand; at the upper and lower limits, the central bank commits to buy or sell its currency, or to change interest rates, so that the rate does not move further. Economists also call such an arrangement a target zone.

A band sits between the two extremes of exchange-rate policy. A hard currency peg allows almost no movement, while a floating exchange rate has no official limits at all. Bands vary in width, from fractions of a percent to fifteen percent or more, and in whether the central rate is fixed, moved in a series of small steps (a crawling band), or set against a currency basket rather than a single anchor currency.

Imagine a dog on a long lead in a park. The dog can wander, sniff and change direction as it likes, but only until the lead runs out. At that point the owner pulls it back. An exchange-rate band works the same way: the currency moves freely for most of the time, and the central bank only steps in when it reaches the end of the lead.

A short lead keeps the dog almost at heel, which is close to a fixed rate. A very long lead gives so much freedom that the dog is nearly running loose, which is close to a float. In a crawling band, the owner keeps walking slowly in one direction, so the space the dog can explore moves along too, usually because the country's prices are rising faster than those of its trading partners.

A band is set by a central rate and a maximum percentage deviation either side of it. The limits are:

• $S_c$ is the central rate, in units of domestic currency per unit of the anchor.
• $b$ is the permitted deviation, written as a decimal.
• $S_{\text{upper}}$ and $S_{\text{lower}}$ are the weak-side and strong-side intervention rates.

The Danish krone has a central rate of 7.46038 kroner per euro and a band of ±2.25%. Its limits are $7.46038 \times 1.0225 = 7.6282$ and $7.46038 \times 0.9775 = 7.2925$, so the krone may trade between about 7.29 and 7.63 per euro. In practice Danmarks Nationalbank keeps it far closer to the centre.

Under the Bretton Woods system, members kept their currencies within 1% of a declared par value against the US dollar. The Smithsonian Agreement of December 1971 widened the margins to 2.25%. When the European Monetary System began in March 1979, its Exchange Rate Mechanism (ERM) used a grid of bilateral bands of ±2.25%, with ±6% allowed for some members, including Italy at first and later Spain, Portugal and the United Kingdom.

The ERM crisis showed the limits of narrow bands under free capital movement. The pound and the Italian lira left the mechanism in September 1992, the pound on "Black Wednesday", 16 September, after heavy selling of sterling. Further attacks followed, and on 2 August 1993 the standard band was widened to ±15%. Its successor, ERM II, launched on 1 January 1999 with a standard band of ±15%; Denmark chose the narrow ±2.25% band. After Bulgaria adopted the euro on 1 January 2026, the krone was the only currency left in ERM II.

Countries with higher inflation than their anchor have often used crawling bands, in which the central rate moves by a preset amount to avoid a steady loss of competitiveness. Chile operated an exchange-rate band from 1984 and abandoned it for a free float in September 1999; Israel switched from a fixed band to a crawling band in December 1991. Several other examples are worth noting:

• Hong Kong. The Linked Exchange Rate System is a very tight band of HK$7.75 to HK$7.85 per US dollar under currency-board rules.
• China. The People's Bank of China lets the onshore yuan move up to 2% either side of a daily central parity, a limit set in March 2014.
• Informal bands. Some central banks never publish their limits but intervene when the rate leaves an unannounced range, a practice often called a managed float.

Paul Krugman's 1991 paper "Target Zones and Exchange Rate Dynamics" argued that a credible band stabilises the rate even inside the limits, because traders expect intervention near the edges and sell or buy in advance, an effect known as the honeymoon effect. Later research found that the effect depends on credibility; when markets doubt the commitment, rates tend to cluster near the edges instead.

That points to the main weakness. A band is a promise that must be defended with foreign exchange reserves or interest rates. With high capital mobility, the impossible trinity means the central bank gives up much of its control over domestic interest rates while it defends the band. If speculators believe a devaluation is coming, the cost of defence can rise quickly, as the ERM crisis showed.

• European Commission: ERM II, the EU's exchange rate mechanism