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Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion

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Miller, Marcus
Zhang, Lei

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Abstract

Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1031.

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Date of creation: Oct 1994
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Handle: RePEc:cpr:ceprdp:1031

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Related research
Keywords: ERM Regulated Brownian Motion Target Zones Time Consistent Policy

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Find related papers by JEL classification:
E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
F31 - International Economics - - International Finance - - - Foreign Exchange
F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

Cited by:
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  1. Amador, Joao L. M., 1999. "Optimal Budget Deficit Rules," FEUNL Working Paper Series wp385, Universidade Nova de Lisboa, Faculdade de Economia. [Downloadable!]
  2. Cukierman, Alex & Goldstein, Itay & Spiegel, Yossi, 2003. "The Choice of Exchange Rate Regime and Speculative Attacks," CEPR Discussion Papers 3714, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  3. Robert Amano & Richard Black & Marcel Kasumovich, 1997. "A Band-Aid Solution to Inflation Targeting," Working Papers 97-11, Bank of Canada. [Downloadable!]
  4. Miklós Koren, 2000. "Implicit Band within the Announced Exchange Rate Band," Rajk László Szakkollégium Working Papers 5, Rajk László College. [Downloadable!]
  5. Joon-Hwan Im, 2001. "Optimal Currency Target Zones: How Wide Should Exchange Rate Bands Be?," International Economic Journal, Korean International Economic Association, vol. 15(1), pages 61-93, April. [Downloadable!] (restricted)
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