Exchange rate target zones and stock price volatility

We show how agents' rational expectations regarding the state-contingent ac tivation of policy instruments do not only impact the asset price it is des igned to affect but spill over onto the entire range of asset prices in an economy. We present an application to exchange rate target zones as a state -contingent instrument for monetary policy. In particular we find that any explicit credible target zone for the exchange rate is associated with an i mplicit target zone for the stock price where the non-linearity of the exch ange rate function translates into a corresponding stabilizing non-linearit y of the stock price path. Copyright (C) 1999 John Wiley & Sons, Ltd.