How tight should one's hands be tied? Fear of floating and credibility of exchange rate regimes (original) (raw)

Target zones for exchange rates and policy changes

Journal of International Money and Finance, 2006

We extend a target zone model to allow for occasional changes in the policy regime which change the stochastic process driving fundamentals. A scenario we have in mind is that macroeconomic policy alternates between relatively tight and loose regimes. A key implication of our analysis is that occurrences which have the appearance of speculative attacks on a currency may be associated with market perceptions of a policy regime switch having taken place. This applies both to a sudden weakening and strengthening of a currency. Our model provides an explanation, based on fundamentals, why large changes in the exchange rate might be associated with no discernible contemporaneous change in the fundamental. Therefore the model provides an explanation for this phenomenon that is an alternative to explanations based on self-fulfilling expectations. Compared with most other models of target zones, other than those relying on intra-marginal intervention, this model is better able to reproduce key features of empirical distributions of exchange rates within the band. The distribution generated by our model has more mass at the centre and less at the edges of the band than is the case for most other models.

On the Choice of an Exchange Rate Regime: Target Zones Revisited

2003

From the classical gold standard up to the current ERM2 arrangement of the European Union, target zones have been a widely used exchange regime in contemporary history. This paper presents a benchmark model that rationalizes the choice of target zones over the rest of regimes: the fixed rate, the free float and the managed float. It is shown that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature that previous models were not able to generate, namely, the positive relation between the exchange rate and the interest rate differential, the degree of non-linearity of the function linking the exchage rate to fundamentals and the shape of the exchange rate stochastic distribution.

Estimating the credibility of an exchange rate target zone

Journal of International Money and Finance, 1997

Recent breakthroughs in the theory of exchange rate target zones have not been followed by similar contributions on the empirical side. The drift adjustment method of evaluating the credibility of a target zone has become common practice. However, the estimates of the expected rate of depreciation inside the band do not model knowledge of the band in the agents' information set. In this paper, a rational expectations limited-dependent variable method to estimate the expected rate of depreciation is used to remedy this weakness. In the case of the franc mark target zone with daily data covering a 4-year period, we show that expected rates of devaluation of the order of 2.5% were still present in the early 1990s. Their reappearance in the autumn of 1992 may thus not be surprising.

The choice of exchange rate bands: balancing credibility and flexibility

Journal of International Economics, 2004

This paper develops a framework for the optimal choice of exchange rate bands within an environment in which policymakers dislike nominal exchange rate variability, but value the flexibility to adjust the nominal exchange rate in response to shocks, in order to attain real exchange rate objectives. The paper provides an endogenous characterization of the optimal exchange rate band in terms of the underlying distribution of shocks to the current and capital accounts of the balance of payments and in terms of the commitment reputation of policymakers.

The Optimal Degree of Exchange Rate Flexibility: a Target Zone Approach &ast

Review of International Economics - Rev Int Econ, 2007

This paper presents a benchmark model that rationalizes the choice of the degree of exchange rate flexibility. We show that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature on target zones that previous models were not able to generate jointly—namely, the positive relation between the exchange rate and the interest rate differential, the degree of nonlinearity of the function linking the exchange rate to fundamentals, and the shape of the exchange rate stochastic distribution.

The Optimal Degree of Exchange Rate Flexibility: a Target Zone Approach

Review of International Economics, 2007

This paper presents a benchmark model that rationalizes the choice of the degree of exchange rate flexibility. We show that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature on target zones that previous models were not able to generate jointly, namely, the positive relation between the exchange rate and the interest rate differential, the degree of non-linearity of the function linking the exchage rate to fundamentals and the shape of the exchange rate stochastic distribution.