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On the Choice of an Exchange Regime: Target Zones Revisited

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Abstract

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 stylised facts in the empirical literature that previous models were not able to produce, namely, the positive relation between the exchange rate and the interest rate differential, the degree of non-linearity of the function linking the exchange rate to fundamentals and the shape of the exchange rate stochastic distribution.

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Paper provided by Centro de Estudios Andaluces in its series Economic Working Papers at Centro de Estudios Andaluces with number E2002/10.

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Length: 34 pages
Date of creation: 2002
Date of revision:
Handle: RePEc:cea:doctra:e2002_10

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Keywords: Infrastructures; taxes; efficiency; social welfare;

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References

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  1. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
  2. Bekaert, Geert & Gray, Stephen F., 1998. "Target zones and exchange rates:: An empirical investigation," Journal of International Economics, Elsevier, Elsevier, vol. 45(1), pages 1-35, June.
  3. Froot, Kenneth & Obstfeld, Maurice, 1991. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," CEPR Discussion Papers, C.E.P.R. Discussion Papers 522, C.E.P.R. Discussion Papers.
  4. Ayuso, Juan & Restoy, Fernando, 1996. "Interest rate parity and foreign exchange risk premia in the ERM," Journal of International Money and Finance, Elsevier, Elsevier, vol. 15(3), pages 369-382, June.
  5. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 6(4), pages 119-144, Fall.
  6. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, Elsevier, vol. 19(1-2), pages 47-66, August.
  7. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(3), pages 669-82, August.
  8. Eduardo Levy-Yeyati, 2011. "Exchange Rate Regimes," Business School Working Papers, Universidad Torcuato Di Tella 2011-02, Universidad Torcuato Di Tella.
  9. Stanley Fischer, 2001. "Exchange Rate Regimes: Is the Bipolar View Correct?," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 15(2), pages 3-24, Spring.
  10. Carmen M. Reinhart, 2000. "Mirage of Floating Exchange Rates," American Economic Review, American Economic Association, American Economic Association, vol. 90(2), pages 65-70, May.
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  13. Kenneth A. Froot & Maurice Obstfeld, 1989. "Stochastic Process Switching: Some Simple Solutions," NBER Working Papers 2998, National Bureau of Economic Research, Inc.
  14. Svensson, Lars E O, 1991. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," CEPR Discussion Papers, C.E.P.R. Discussion Papers 494, C.E.P.R. Discussion Papers.
  15. Svensson, Lars E. O., 1991. "The term structure of interest rate differentials in a target zone : Theory and Swedish data," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(1), pages 87-116, August.
  16. Lindberg, Hans & Soderlind, Paul, 1994. " Intervention Policy and Mean Reversion in Exchange Rate Target Zones: The Swedish Case," Scandinavian Journal of Economics, Wiley Blackwell, Wiley Blackwell, vol. 96(4), pages 499-513.
  17. Lars E. O. Svensson, 1991. "The Simplest Test of Target Zone Credibility," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 655-665, September.
  18. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  19. Robert P. Flood & Andrew K. Rose & Donald J. Mathieson, 1990. "An Empirical Exploration of Exchange Rate Target-Zones," NBER Working Papers 3543, National Bureau of Economic Research, Inc.
  20. Krugman, Paul & Miller, Marcus, 1993. "Why have a target zone?," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 38(1), pages 279-314, June.
  21. Giuseppe Bertola & Lars E.O. Svensson, 1991. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," NBER Working Papers 3576, National Bureau of Economic Research, Inc.
  22. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, American Economic Association, vol. 80(2), pages 192-96, May.
  23. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, Elsevier, vol. 32(5), pages 1055-1075, June.
  24. Bertola, G. & Cabarello, R.J., 1990. "Target Zones And Realignments," Discussion Papers, Columbia University, Department of Economics 1990_51, Columbia University, Department of Economics.
  25. Reinhart, Carmen, 2000. "The mirage of floating exchange rates," MPRA Paper 13736, University Library of Munich, Germany.
  26. Lewis, Karen K, 1995. "Occasional Interventions to Target Rates," American Economic Review, American Economic Association, American Economic Association, vol. 85(4), pages 691-715, September.
  27. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, Elsevier, vol. 36(1-2), pages 29-52, February.
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Cited by:
  1. Jesus Rodriguez Lopez & Hugo Rodriguez Mendizabal, 2003. "How tight should one's hands be tied? Fear of floating and credibility of exchange rate regimes," UFAE and IAE Working Papers, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC) 593.03, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  2. Antonio Morales & Pablo Brañas Garza, 2003. "Computational Errors in Guessing Games1," Economic Working Papers at Centro de Estudios Andaluces, Centro de Estudios Andaluces E2003/11, Centro de Estudios Andaluces.
  3. Jesús Rodríguez López & Hugo Rodríguez Mendizábal, 2003. "How Tight Should Central Bank’s Hands be Tied? Credibility, Volatility and the Optimal Band Width of a Target Zone," Economic Working Papers at Centro de Estudios Andaluces, Centro de Estudios Andaluces E2003/24, Centro de Estudios Andaluces.
  4. Jesús Rodríguez López & Hugo Rodríguez Mendizábal, 2006. "How tight should one's hands be tied? Fear of floating and credibility of exchange regimes," Working Papers 06.03, Universidad Pablo de Olavide, Department of Economics.

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