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How tight should one's hands be tied? Fear of floating and credibility of exchange regimes

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  • Jesús Rodríguez López

    ()
    (Department of Economics, Universidad Pablo de Olavide)

  • Hugo Rodríguez Mendizábal

    ()
    (Department of Economics, Universidad Autónoma de Barcelona)

Abstract

The literature on exchange regimes has recently observed that officially self-declared free floaters strongly intervene their nominal exchange rates to maintain them within some unannounced bands. In this paper, we provide an explanation for this behavior, labeled by Calvo and Reinhart (2002) as fear of floating. First, we analyze the linkages between the credibility of the exchange regime, the volatility of the exchange rate and the band width of fluctuation. Second, the model is used to understand the reduction in volatility experienced by most ERM countries after their target zones were widened on August 1993. Finally, solving the model for a subgame perfect equilibrium, fear of floating can be viewed as the credible choice of a finite non-zero band

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File URL: http://www.upo.es/serv/bib/wps/econ0603.pdf
File Function: First version, 2006
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Bibliographic Info

Paper provided by Universidad Pablo de Olavide, Department of Economics in its series Working Papers with number 06.03.

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Length: 36 pages
Date of creation: Mar 2006
Date of revision:
Handle: RePEc:pab:wpaper:06.03

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Keywords: Fear of floating; target zones; exchange rate arrangements; credibility;

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  1. Stockman, Alan C., 1999. "Choosing an exchange-rate system," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1483-1498, October.
  2. Lars E.O. Svensson, 1990. "The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk," NBER Working Papers 3466, National Bureau of Economic Research, Inc.
  3. 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.
  4. 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.
  5. Jess Rodr?uez L?ez & Hugo Rodr?uez Mendiz?al, 2002. "On the Choice of an Exchange Rate Regime: Target Zones Revisited," UFAE and IAE Working Papers 518.02, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  6. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
  7. Lars E. O. Svensson, 1992. "An Interpretation of Recent Research on Exchange Rate Target Zones," Journal of Economic Perspectives, American Economic Association, vol. 6(4), pages 119-144, Fall.
  8. Carmen M. Reinhart, 2000. "Mirage of Floating Exchange Rates," American Economic Review, American Economic Association, vol. 90(2), pages 65-70, May.
  9. Lars E.O. Svensson, 1990. "The Simplest Test of Target Zone Credibility," NBER Working Papers 3394, National Bureau of Economic Research, Inc.
  10. Maurice Obstfeld & Kenneth Rogoff, 1995. "The mirage of fixed exchange rates," Working Papers in Applied Economic Theory 95-08, Federal Reserve Bank of San Francisco.
  11. Lars E.O. Svensson, 1992. "Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates," NBER Working Papers 4207, National Bureau of Economic Research, Inc.
  12. Gomez-Puig, Marta & Montalvo, JoseG., 1997. "A new indicator to assess the credibility of the EMS," European Economic Review, Elsevier, vol. 41(8), pages 1511-1535, August.
  13. 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.
  14. Ayuso, Juan & Restoy, Fernando, 1996. "Interest rate parity and foreign exchange risk premia in the ERM," Journal of International Money and Finance, Elsevier, vol. 15(3), pages 369-382, June.
  15. Bertola, G. & Svensson, L.E., 1990. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," Papers 481, Stockholm - International Economic Studies.
  16. 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 E2002/10, Centro de Estudios Andaluces.
  17. Chen, Zhaohui & Giovannini, Alberto, 1992. "Target zones and the distribution of exchange rates: An estimation method," Economics Letters, Elsevier, vol. 40(1), pages 83-89, September.
  18. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  19. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  20. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, vol. 36(1-2), pages 29-52, February.
  21. Giavazzi, Francesco & Pagano, Marco, 1988. "The advantage of tying one's hands : EMS discipline and Central Bank credibility," European Economic Review, Elsevier, vol. 32(5), pages 1055-1075, June.
  22. Labhard, Vincent & Wyplosz, Charles, 1996. "The New EMS: Narrow Bands inside Deep Bands," American Economic Review, American Economic Association, vol. 86(2), pages 143-46, May.
  23. Bekaert, Geert, 1995. "The Time Variation of Expected Returns and Volatility in Foreign-Exchange Markets," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(4), pages 397-408, October.
  24. Francisco Ledesma-Rodriguez & Manuel Navarro-Ibanez & Jorge Perez-Rodriguez & Simon Sosvilla-Rivero, 2000. "On the Credibility of the Irish Pound in the EMS," The Economic and Social Review, Economic and Social Studies, vol. 31(2), pages 151-172.
  25. Reinhart, Carmen, 2000. "The mirage of floating exchange rates," MPRA Paper 13736, University Library of Munich, Germany.
  26. Ball, Clifford A. & Roma, Antonio, 1993. "A jump diffusion model for the European monetary system," Journal of International Money and Finance, Elsevier, vol. 12(5), pages 475-492, October.
  27. Stanley Fischer, 2001. "Exchange Rate Regimes: Is the Bipolar View Correct?," Journal of Economic Perspectives, American Economic Association, vol. 15(2), pages 3-24, Spring.
  28. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August.
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