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Exchange Rate Bands and Optimal Monetary Accommodation Under a Dirty Float

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  • Beetsma, Roel
  • van der Ploeg, Frederick

Abstract

This paper studies regimes of managed exchange rates for a small open economy with an integrated capital market, rational expectations in financial markets, sluggish nominal wages and prices, and supply shocks that follow a Brownian motion. Each regime can be characterized by the degree to which price shocks are accommodated and the width of the exchange rate band. Special cases of monetary accommodation are a peg, a clean float and a PPP exchange rate rule. First, the optimal degree of monetary accommodation of price shocks is analysed when there is no exchange rate band. Given that the welfare loss is a weighted sum of the asymptotic variances of output and of consumer prices, monetary accommodation is particularly strong when the authorities care relatively more about full employment than price stability. More flexible labour markets induce right-wing governments to move towards a cleaner float and left-wing governments towards a PPP exchange rate rule. Second, the effects of exchange rate bands and the accompanying inframarginal interventions are examined when allowance is made for intramarginal interventions as well. Such a framework can, in contrast to the pioneering Krugman analysis, explain the observed hump-shaped unconditional density functions of EMS exchange rates.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 725.

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Date of creation: Oct 1992
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Handle: RePEc:cpr:ceprdp:725

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Related research

Keywords: Brownian Motion; Dirty Floating; Exchange Rate Regimes; PPP Exchange Rate Rules; Stochastic Simulation; Supply Shocks;

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Cited by:
  1. Bekaert, G.R.J. & Gray, S.F., 1997. "Target zones and exchange rates: An empirical investigation," Discussion Paper 1997-22, Tilburg University, Center for Economic Research.
  2. Beetsma, R.M.W.J. & Ploeg, F. van der, 1993. "Intramarginal interventions, bands and the pattern of EMS exchange rate distributions," Discussion Paper 1993-48, Tilburg University, Center for Economic Research.
  3. Svensson, Lars E O, 1992. "Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates," CEPR Discussion Papers 742, C.E.P.R. Discussion Papers.
  4. Alan Sutherland, . "Monetary and Real Shocks and the Optimal Target Zone," Discussion Papers 92/7, Department of Economics, University of York.

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