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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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  10. Reinhart, Carmen, 2000. "The mirage of floating exchange rates," MPRA Paper 13736, University Library of Munich, Germany.
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  19. 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.
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  21. 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.
  22. Bekaert, Geert, 1995. "The Time Variation of Expected Returns and Volatility in Foreign-Exchange Markets," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(4), pages 397-408, October.
  23. Obstfeld, Maurice, 1996. "Models of Currency Crises with Self-fulfilling Features," CEPR Discussion Papers 1315, C.E.P.R. Discussion Papers.
  24. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August.
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  26. 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.
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