The paper provides an explanation to the policy of implicit exchange rate bands. Especially when introducing a new exchange rate band or modifying the old one, central banks often intervene intra-marginally, targeting a narrower band than that announced. The theoretical literature provides little clue to understand this phenomenon. The models either do not differ-entiate between the mechanism of announced (known) and implicit (unknown) exchange rate bands, or fail to account for the central bank's incentives in exchange rate policy. I present a model, which both distinguishes the announced from the true target zone and endogenizes the choice of the bandwidth. I argue that implicit bands are a mean to signal the objectives of exchange rate policy. Announcement of the bandwidth cannot credibly do this, since it is not binding for the central bank. That is, the announcement is only partially believed. On the other hand, the choice of the actual bandwidth may serve as a costly signal. Since stability-concerned central banks are more likely to accept the costs of intervening intra-marginally, narrow implicit bands may effectively communicate the preferences for exchange rate stabil-ity. I conclude that a low level of reputation and a high concern of exchange rate stability both make the policy of implicit band more likely.
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Find related papers by JEL classification: F31 - International Economics - - International Finance - - - Foreign Exchange E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
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Backus, David & Driffill, John, 1985.
"Inflation and Reputation,"
American Economic Review,
American Economic Association, vol. 75(3), pages 530-38, June.
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