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Target Zones for Exchange Rates and Policy Changes

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  • John Driffill (Birkbeck College)
  • Martin Sola (UTDT)

Abstract

We extend a target zone model to allow for occasional changes in the policy regime which change the stochastic process driving fundamentals. A scenario we have in mind is that macroeconomic policy alternates between relatively tight and loose regimes. A key implication of our analysis is that occurrences which have the appearance of speculative attacks on a currency may be associated with market perceptions of a policy regime switch having taken place. This applies both to a sudden weakening and strengthening of a currency. Our model provides an explanation, based on fundamentals, why large changes in the exchange rate might be associated with no discernible contemporaneous change in the fundamental. Therefore the model provides an explanation for this phenomenon that is an alternative to explanations based on self-fulfilling expectations. Compared with most other models of target zones, other than those relying on intra-marginal intervention, this model is better able to reproduce key features of empirical distributions of exchange rates within the band. The distribution generated by our model has more mass at the centre and less at the edges of the band than is the case for most other models.

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Bibliographic Info

Paper provided by Universidad Torcuato Di Tella in its series Department of Economics Working Papers with number 2005-03.

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Length: 28 pages
Date of creation: Mar 2005
Date of revision:
Handle: RePEc:udt:wpecon:2005-03

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Web page: http://www.utdt.edu/ver_contenido.php?id_contenido=439&id_item_menu=568
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Related research

Keywords: stochastic regime-switching; exchange rates; target zones. JEL Classification: F31; F41;

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References

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  1. Campa, Jose M & Chang, P H Kevin, 1998. "ERM Realignment Risk and Its Economic Determinants as Reflected in Cross-Rate Options," Economic Journal, Royal Economic Society, vol. 108(449), pages 1046-66, July.
  2. Andrew K. Rose & Lars E.O. Svensson, 1991. "Expected and predicted realignments: the FF/DM exchange rate during the EMS," International Finance Discussion Papers 395, Board of Governors of the Federal Reserve System (U.S.).
  3. Flood, Robert P. & Rose, Andrew K. & Mathieson, Donald J., 1991. "An empirical exploration of exchange-rate target-zones," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 35(1), pages 7-65, January.
  4. Sola, Martin & Driffill, John, 1994. "Testing the term structure of interest rates using a stationary vector autoregression with regime switching," Journal of Economic Dynamics and Control, Elsevier, vol. 18(3-4), pages 601-628.
  5. Miller, Marcus & Sutherland, Alan, 1990. "Britain's Return to Gold and Entry into the EMS: Expectations, Joining Conditions and Credibility," CEPR Discussion Papers 465, C.E.P.R. Discussion Papers.
  6. Robert P. Flood & Peter M. Garber, 1989. "The Linkage Between Speculative Attack and Target Zone Models of Exchange Rates," NBER Working Papers 2918, National Bureau of Economic Research, Inc.
  7. Maurice Obstfeld, 1984. "Rational and Self-Fulfilling Balance-of-Payments Crises," NBER Working Papers 1486, National Bureau of Economic Research, Inc.
  8. Bertola, G. & Svensson, L.E., 1990. "Stochastic Devaluation Risk and the Empirical Fit of Target Zone Models," Papers 481, Stockholm - International Economic Studies.
  9. Obstfeld, Maurice, 1996. "Models of Currency Crises with Self-fulfilling Features," CEPR Discussion Papers 1315, C.E.P.R. Discussion Papers.
  10. Willman, Alpo, 1987. "Speculative attacks on the currency with uncertain monetary policy reactions," Economics Letters, Elsevier, vol. 25(1), pages 75-78.
  11. Tristani, Oreste, 1994. " Variable Probability of Realignment in a Target Zone," Scandinavian Journal of Economics, Wiley Blackwell, vol. 96(1), pages 1-14.
  12. Froot, Kenneth A. & Obstfeld, Maurice, 1991. "Exchange-rate dynamics under stochastic regime shifts : A unified approach," Journal of International Economics, Elsevier, vol. 31(3-4), pages 203-229, November.
  13. Blackburn, Keith & Sola, Martin, 1993. " Speculative Currency Attacks and Balance of Payments Crises," Journal of Economic Surveys, Wiley Blackwell, vol. 7(2), pages 119-44, June.
  14. Driffill, John & Sola, Martin, 1998. "Intrinsic bubbles and regime-switching," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 357-373, July.
  15. Paul Krugman & Marcus Miller, 1992. "Exchange Rate Targets and Currency Bands," NBER Books, National Bureau of Economic Research, Inc, number krug92-1.
  16. 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.
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Citations

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Cited by:
  1. Christian Bauer & Paul De Grauwe & Stefan Reitz, 2007. "Exchange Rates Dynamics in a Target Zone – A Heterogeneous Expectations Approach," CESifo Working Paper Series 2080, CESifo Group Munich.
  2. António Portugal Duarte & João Sousa Andrade & Adelaide Duarte, 2010. "Exchange Rate Target Zones: A Survey of the Literature," GEMF Working Papers 2010-14, GEMF - Faculdade de Economia, Universidade de Coimbra.

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