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

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

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Jesus Rodriguez Lopez
Hugo Rodriguez Mendizabal ()

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Abstract

This paper analyzes the linkages between the credibility of a target zone regime, the volatility of the exchange rate, and the width of the band where the exchange rate is allowed to fluctuate. These three concepts should be related since the band width induces a trade-off between credibility and volatility. Narrower bands should give less scope for the exchange rate to fluctuate but may make agents perceive a larger probability of realignment which by itself should increase the volatility of the exchange rate. We build a model where this trade-off is made explicit. The model is used to understand the reduction in volatility experienced by most EMS countries after their target zones were widened on August 1993. As a natural extension, the model also rationalizes the existence of non-official, implicit target zones (or fear of floating), suggested by some authors.

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Paper provided by Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC) in its series UFAE and IAE Working Papers with number 593.03.

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Length: 34
Date of creation: 21 Oct 2003
Date of revision:
Handle: RePEc:aub:autbar:593.03

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
F31 - International Economics - - International Finance - - - Foreign Exchange
F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

This paper has been announced in the following NEP Reports:

NEP-ALL-2003-10-28 (All new papers)
NEP-EEC-2003-10-28 (European Economics)
NEP-RMG-2003-10-28 (Risk Management)

References listed on IDEAS
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