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How Tight Should Central Bank’s Hands be Tied? Credibility, Volatility and the Optimal Band Width of a Target Zone

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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 give less scope for the exchange rate to fluctuate but may make agents perceive a larger probability of realignment which by itself increases 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 currencies 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, suggested by some authors.

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Bibliographic Info

Paper provided by Centro de Estudios Andaluces in its series Economic Working Papers at Centro de Estudios Andaluces with number E2003/24.

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Length: 36 pages
Date of creation: 2003
Date of revision:
Handle: RePEc:cea:doctra:e2003_24

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Keywords: Target zones; exchange rate agreements; monetary policy; rational expectations; credibility.;

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References

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  1. Stockman, Alan C., 1999. "Choosing an exchange-rate system," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1483-1498, October.
  2. Francisco Ledesma-Rodriguez & Manuel Navarro-Ibanez & Jorge Perez-Rodriguez & Simon Sosvilla-Rivero, 2000. "On the Credibility of the Irish Pound in the EMS," The Economic and Social Review, Economic and Social Studies, vol. 31(2), pages 151-172.
  3. Maurice Obstfeld & Kenneth Rogoff, 1995. "The mirage of fixed exchange rates," Working Papers in Applied Economic Theory 95-08, Federal Reserve Bank of San Francisco.
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  7. Lars E.O. Svensson, 1990. "The Simplest Test of Target Zone Credibility," NBER Working Papers 3394, National Bureau of Economic Research, Inc.
  8. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
  9. 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.
  10. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August.
  11. Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2005. "Classifying exchange rate regimes: Deeds vs. words," European Economic Review, Elsevier, vol. 49(6), pages 1603-1635, August.
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  13. Francesco Giavazzi & Marco Pagano, 1991. "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 303-330 National Bureau of Economic Research, Inc.
  14. Svensson, L.E.O., 1993. "Fixed Exchange Rates As a Means to Price Stability: What Have we Learned?," Papers 553, Stockholm - International Economic Studies.
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  18. Jesús Rodríguez López & Hugo Rodríguez Mendizábal, 2002. "On the Choice of an Exchange Regime: Target Zones Revisited," Economic Working Papers at Centro de Estudios Andaluces E2002/10, Centro de Estudios Andaluces.
  19. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
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  21. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
  22. Bertola, Giuseppe & Svensson, Lars E O, 1991. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," CEPR Discussion Papers 513, C.E.P.R. Discussion Papers.
  23. Ayuso, Juan & Restoy, Fernando, 1996. "Interest rate parity and foreign exchange risk premia in the ERM," Journal of International Money and Finance, Elsevier, vol. 15(3), pages 369-382, June.
  24. Labhard, Vincent & Wyplosz, Charles, 1996. "The New EMS: Narrow Bands inside Deep Bands," American Economic Review, American Economic Association, vol. 86(2), pages 143-46, May.
  25. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
  26. Reinhart, Carmen, 2000. "The mirage of floating exchange rates," MPRA Paper 13736, University Library of Munich, Germany.
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