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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. 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, Centro de Estudios Andaluces E2002/10, Centro de Estudios Andaluces.
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  11. Lars E.O. Svensson, 1993. "Fixed Exchange Rates as a Means to Price Stability: What Have We Learned," NBER Working Papers 4504, National Bureau of Economic Research, Inc.
  12. 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.
  13. 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.
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  16. 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.
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  18. Labhard, Vincent & Wyplosz, Charles, 1996. "The New EMS: Narrow Bands inside Deep Bands," American Economic Review, American Economic Association, American Economic Association, vol. 86(2), pages 143-46, May.
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  20. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  21. Lars E. O. Svensson, 1991. "The Simplest Test of Target Zone Credibility," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 655-665, September.
  22. Stockman, Alan C., 1999. "Choosing an exchange-rate system," Journal of Banking & Finance, Elsevier, Elsevier, vol. 23(10), pages 1483-1498, October.
  23. Francesco Giavazzi & Marco Pagano, 1991. "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," NBER Chapters, National Bureau of Economic Research, Inc, 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.
  24. Gomez-Puig, Marta & Montalvo, JoseG., 1997. "A new indicator to assess the credibility of the EMS," European Economic Review, Elsevier, Elsevier, vol. 41(8), pages 1511-1535, August.
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  27. Reinhart, Carmen, 2000. "The mirage of floating exchange rates," MPRA Paper 13736, University Library of Munich, Germany.
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