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Optimal target zones: How an exchange rate mechanism can improve upon discretion

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  • Miller, Marcus
  • Zhang, Lei

Abstract

Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 20 (1996)
Issue (Month): 9-10 ()
Pages: 1641-1660

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Handle: RePEc:eee:dyncon:v:20:y:1996:i:9-10:p:1641-1660

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References

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  1. Svensson, Lars E O, 1992. "Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates," CEPR Discussion Papers 742, C.E.P.R. Discussion Papers.
  2. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 473-91, June.
  3. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  4. Svensson, Lars E O, 1990. "Target Zones and Interest Rate Variability," CEPR Discussion Papers 372, C.E.P.R. Discussion Papers.
  5. Cohen, Daniel & Michel, Philippe, 1988. "How Should Control Theory Be Used to Calculate a Time-Consistent Government Policy?," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 55(2), pages 263-74, April.
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Cited by:
  1. Miller, Marcus & Zhang, Lei, 1997. "Hyperinflation and Stabilisation: Cagan Revisited," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 107(441), pages 441-54, March.
  2. Cukierman, Alex & Spiegel, Yossi & Leiderman, Leonardo, 2004. "The choice of exchange rate bands: balancing credibility and flexibility," Journal of International Economics, Elsevier, vol. 62(2), pages 379-408, March.
  3. Lee, Hsiu-Yun & Lai, Hung-Pin, 2011. "A structural threshold model of the exchange rate under optimal intervention," Journal of International Money and Finance, Elsevier, Elsevier, vol. 30(6), pages 931-946, October.
  4. Alex Cukierman & Itay Goldstein & Yossi Spiegel, 2004. "The Choice of Exchange-Rate Regime and Speculative Attacks," Journal of the European Economic Association, MIT Press, MIT Press, vol. 2(6), pages 1206-1241, December.
  5. Gregory Gagnon, 2012. "Exchange rate bifurcation in a stochastic evolutionary finance model," Decisions in Economics and Finance, Springer, vol. 35(1), pages 29-58, May.
  6. Cadenillas, Abel & Zapatero, Fernando, 1999. "Optimal Central Bank Intervention in the Foreign Exchange Market," Journal of Economic Theory, Elsevier, vol. 87(1), pages 218-242, July.
  7. Joon-Hwan Im, 2001. "Optimal Currency Target Zones: How Wide Should Exchange Rate Bands Be?," International Economic Journal, Taylor & Francis Journals, Taylor & Francis Journals, vol. 15(1), pages 61-93.
  8. Mundaca, Gabriela & Oksendal, Bernt, 1998. "Optimal stochastic intervention control with application to the exchange rate," Journal of Mathematical Economics, Elsevier, vol. 29(2), pages 225-243, March.
  9. Inci, Ahmet Can, 2005. "ERM effects on currency spot and futures markets," Global Finance Journal, Elsevier, vol. 16(2), pages 145-163, December.
  10. Lee, Hsiu-Yun, 2011. "Nonlinear exchange rate dynamics under stochastic official intervention," Economic Modelling, Elsevier, vol. 28(4), pages 1510-1518, July.
  11. Robert Amano & Richard Black & Marcel Kasumovich, 1997. "A Band-Aid Solution to Inflation Targeting," Working Papers 97-11, Bank of Canada.
  12. Amador, Joao L. M., 1999. "Optimal Budget Deficit Rules," FEUNL Working Paper Series wp385, Universidade Nova de Lisboa, Faculdade de Economia.
  13. Lin, Hwan C., 2008. "Forward-rate target zones and exchange rate dynamics," Journal of International Money and Finance, Elsevier, Elsevier, vol. 27(5), pages 831-846, September.

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