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Optimal target zones: How an exchange rate mechanism can improve upon discretion

  • Miller, Marcus
  • Zhang, Lei

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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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 20 (1996)
Issue (Month): 9-10 ()
Pages: 1641-1660

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Handle: RePEc:eee:dyncon:v:20:y:1996:i:9-10:p:1641-1660
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  1. Svensson, Lars E O, 1990. "Target Zones and Interest Rate Variability," CEPR Discussion Papers 372, C.E.P.R. Discussion Papers.
  2. 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 473-91, June.
  3. Paul R. Krugman, 1988. "Target Zones and Exchange Rate Dynamics," NBER Working Papers 2481, National Bureau of Economic Research, Inc.
  4. Svensson, L.E.O., 1992. "Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates," Papers 521, Stockholm - International Economic Studies.
  5. Cohen, Daniel & Michel, Philippe, 1988. "How Should Control Theory Be Used to Calculate a Time-Consistent Government Policy?," Review of Economic Studies, Wiley Blackwell, vol. 55(2), pages 263-74, April.
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