Optimal target zones: How an exchange rate mechanism can improve upon discretion
Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.
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- Svensson, Lars E O, 1992.
"Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates,"
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- Svensson, Lars E. O., 1991.
"Target zones and interest rate variability,"
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Elsevier, vol. 31(1-2), pages 27-54, August.
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- Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-491, June.
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