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Exchange Rate Bands and Realignments in a Stationary Stochastic Setting

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  • Miller, Marcus
  • Weller, Paul

Abstract

The extent which exchange rate management can coexist with an independent monetary policy is examined in the context of a model with exchange rate bands. Using a Dornbusch model in which stochastic shocks are added to the Phillips curve, we analyze the implications of assuming that the monetary authorities follow certain simple rules for realigning the band when fundamentals have drifted too far from equilibrium. Assuming that information about whether the bands is to be defended or there is to be a realignment is revealed at the point when the exchange rate hits the edge of the band, we show how the path of the exchange rate can be completely characterized in terms of the solution to a second order nonlinear differential equation - together with jumps in the rate at the edge of the band, which satisfy a zero profit arbitrage condit.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 299.

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Date of creation: Apr 1989
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Handle: RePEc:cpr:ceprdp:299

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Keywords: European Monetary System; Exchange Rates; Monetary Policy;

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Cited by:
  1. Bertola, Giuseppe & Svensson, Lars E O, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(3), pages 689-712, July.
  2. Michael Hu & Christine Jiang & Christos Tsoukalas, 2004. "The volatility impact of the European monetary system on member and non-member currencies," Applied Financial Economics, Taylor & Francis Journals, Taylor & Francis Journals, vol. 14(5), pages 313-325.
  3. A.J. Hallet, 1998. "When Do Target Zones Work? An Examination of Exchange Rate Targeting as a Device for Coordinating Economic Policies," Open Economies Review, Springer, Springer, vol. 9(2), pages 115-138, April.
  4. Svensson, L.E., 1990. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," Papers, Stockholm - International Economic Studies 475, Stockholm - International Economic Studies.
  5. M. Hashem Pesaran & Francisco J. Ruge-Murcia, 1996. "Limited-dependent rational expectations models with jumps," Discussion Paper / Institute for Empirical Macroeconomics 111, Federal Reserve Bank of Minneapolis.
  6. Dean Corbae & Chris Neely & Paul Weller, 1998. "Endogenous realignments and the sustainability of a target," Working Papers 1994-009, Federal Reserve Bank of St. Louis.
  7. Lars E. O. Svensson, 1990. "Target Zones and Interest Rate Variability," IMF Working Papers 90/31, International Monetary Fund.
  8. Dominquez, Kathryn M. & Kenen, Peter B., 1992. "Intramarginal intervention in the EMS and the target-zone model of exchange-rate behavior," European Economic Review, Elsevier, vol. 36(8), pages 1523-1532, December.
  9. Pesaran, M.H. & Samiei, H., 1993. "Limited-Dependaent Rational Expectations Models with Future Expectations," Cambridge Working Papers in Economics 9321, Faculty of Economics, University of Cambridge.

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