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How Tight Should One's Hands be Tied? Fear of Floating and the Credibility of Exchange Rate Regimes

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  • Rodríguez-López Jesús

    () (jrodlop@upo.es)

  • Rodriguez Mendizabal Hugo

    () (Universitat Autonoma de Barcelona)

Abstract

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

Suggested Citation

  • Rodríguez-López Jesús & Rodriguez Mendizabal Hugo, 2006. "How Tight Should One's Hands be Tied? Fear of Floating and the Credibility of Exchange Rate Regimes," The B.E. Journal of Macroeconomics, De Gruyter, vol. 6(1), pages 1-25, March.
  • Handle: RePEc:bpj:bejmac:v:topics.6:y:2006:i:1:n:4
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    References listed on IDEAS

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    1. 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.
    2. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
    3. Lars E. O. Svensson, 1991. "The Simplest Test of Target Zone Credibility," IMF Staff Papers, Palgrave Macmillan, vol. 38(3), pages 655-665, September.
    4. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
    5. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," The Quarterly Journal of Economics, Oxford University Press, vol. 119(1), pages 1-48.
    6. Stockman, Alan C., 1999. "Choosing an exchange-rate system," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1483-1498, October.
    7. 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.
    8. 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.
    9. Maurice Obstfeld & Kenneth Rogoff, 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives, American Economic Association, vol. 9(4), pages 73-96, Fall.
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    Cited by:

    1. Jesús Rodríguez López & Hugo Rodríguez Mendizábal, 2007. "The Optimal Degree of Exchange Rate Flexibility: a Target Zone Approach," Review of International Economics, Wiley Blackwell, vol. 15(4), pages 803-822, September.

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