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The optimal degree of exchange rate flexibility: A target zone approach

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Author Info
Jesús Rodríguez López () (Department of Economics, Universidad Pablo de Olavide)
Hugo Rodríguez Mendizábal () (Department of Economics, Universidad Autónoma de Barcelona)

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Abstract

This paper presents a benchmark model that rationalizes the choice of the degree of exchange rate flexibility. We show that the monetary authority may gain efficiency by reducing volatility of both the exchange rate and the interest rate at the same time. Furthermore, the model is consistent with some known stylized facts in the empirical literature on target zones that previous models were not able to generate jointly, namely, the positive relation between the exchange rate and the interest rate differential, the degree of non-linearity of the function linking the exchage rate to fundamentals and the shape of the exchange rate stochastic distribution.

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File URL: http://www.upo.es/serv/bib/wps/econ0622.pdf
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File Function: First version, 2006
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Publisher Info
Paper provided by Universidad Pablo de Olavide, Department of Economics in its series Working Papers with number 06.22.

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Length: 34 pages
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:pab:wpaper:06.22

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Related research
Keywords: Target zones; exchange rate agreements; monetary policy; time consistency.;

Other versions of this item:

Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
F31 - International Economics - - International Finance - - - Foreign Exchange
F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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References listed on IDEAS
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  3. Bertola, Giuseppe & Svensson, Lars E O, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Blackwell Publishing, vol. 60(3), pages 689-712, July. [Downloadable!] (restricted)
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  4. E.O. Svensson, Lars, 1994. "Why exchange rate bands? : Monetary independence in spite of fixed exchange rates," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 157-199, February. [Downloadable!] (restricted)
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  5. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August. [Downloadable!] (restricted)
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  6. de Jong, F, 1994. "A Univariate Analysis of EMS Exchange Rates Using a Target Zone Model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 9(1), pages 31-45, Jan.-Marc. [Downloadable!] (restricted)
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  9. Reinhart, Carmen & Rogoff, Kenneth, 2004. "The modern history of exchange rate arrangements: A reinterpretation," MPRA Paper 14070, University Library of Munich, Germany. [Downloadable!]
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  10. Ken West, 2003. "Monetary policy and the volatility of real exchange rates in New Zealand," Reserve Bank of New Zealand Discussion Paper Series DP2003/09, Reserve Bank of New Zealand. [Downloadable!]
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  11. Kenneth A. Froot & Maurice Obstfeld, 1991. "Stochastic Process Switching: Some Simple Solutions," NBER Working Papers 2998, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-36, June. [Downloadable!] (restricted)
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  13. 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. [Downloadable!] (restricted)
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  16. Svensson, Lars E. O., 1994. "Fixed exchange rates as a means to price stability: What have we learned?," European Economic Review, Elsevier, vol. 38(3-4), pages 447-468, April. [Downloadable!] (restricted)
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  17. Meese, Richard A & Rose, Andrew K, 1990. "Nonlinear, Nonparametric, Nonessential Exchange Rate Estimation," American Economic Review, American Economic Association, vol. 80(2), pages 192-96, May. [Downloadable!] (restricted)
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  19. Lars E.O. Svensson, 1991. "The Term Structure of Interest Rate Differentials in a Target Zone: Theory and Swedish Data," NBER Working Papers 3374, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  20. David Hargreaves, 2003. "Monetary policy and the volatility of real exchange rates in New Zealand," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 66, pages 2, September. [Downloadable!]
  21. Jesús Crespo-Cuaresma & Balázs Égert & Ronald MacDonald, 2005. "Non-Linear Exchange Rate Dynamics in Target Zones: A Bumpy Road Towards A Honeymoon Some Evidence from the ERM, ERM2 and Selected New EU Member States," William Davidson Institute Working Papers Series wp771, William Davidson Institute at the University of Michigan Stephen M. Ross Business School. [Downloadable!]
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  22. Lewis, Karen K, 1995. "Occasional Interventions to Target Rates," American Economic Review, American Economic Association, vol. 85(4), pages 691-715, September. [Downloadable!] (restricted)
  23. repec:bep:mactop:v:6:y:2006:i:1:p:1401-1401 is not listed on IDEAS
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  29. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 73-96, Fall. [Downloadable!] (restricted)
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  30. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August. [Downloadable!] (restricted)
    Other versions:
  31. Robert P. Flood & Andrew K. Rose & Donald J. Mathieson, 1990. "An Empirical Exploration of Exchange Rate Target-Zones," NBER Working Papers 3543, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  32. Catherine S. Forbes & Paul Kofman, 2000. "Bayesian Target Zones," Econometric Society World Congress 2000 Contributed Papers 0575, Econometric Society. [Downloadable!]
  33. 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. [Downloadable!] (restricted)
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  36. repec:rus:hseeco:181565 is not listed on IDEAS
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