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On the Evolution of Credibility and Flexible Exchange Rate Target Zones

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Author Info
Avesani, Renzo
Gallo, Giampiero M
Salmon, Mark

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Abstract

This paper considers a new approach to the optimal management and analysis of exchange rate target zones by regarding the operation of a target zone as a dynamic signalling game between the monetary authorities and the financial markets. A Sequential Open Loop (Feedback) policy of sterilized intervention is proposed that depends critically on the evolution of the policy-maker's credibility as opposed to the open loop precommitment strategy that has been implemented, for instance, in the Exchange Rate Mechanism of the EMS and in the Bretton Woods system. The width of the target zone and realignments are in turn determined optimally given the policy-maker's credibility. A commitment to this form of flexible target zone is shown through simulation to provide substantial stabilization for the exchange rate while retaining considerable flexibility and robustness in response to shocks.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1123.

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Date of creation: Feb 1995
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Handle: RePEc:cpr:ceprdp:1123

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Related research
Keywords: Credibility Dynamic Policy Exchange Rate Target Zones Flexibility Incentive Compatability Sterilized Intervention Signalling

Find related papers by JEL classification:
F02 - International Economics - - General - - - International Economic Order; Noneconomic International Organizations;; Economic Integration and Globalization: General
F31 - International Economics - - International Finance - - - Foreign Exchange
F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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This page was last updated on 2008-9-15.

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