Optimal Currency Target Zones: How Wide Should Exchange Rate Bands Be?
This paper presents a model of an optimal currency band in which a central bank with an infinite time horizon faces a trade-off between interest rate deviation costs and exchange rate deviation costs. The bank chooses optimal intervention points in order to minimize the value of the loss function. The paper uses the Bellman inequalities for instantaneous control of the regulated Brownian motion to derive an optimal currency band and optimal intervention policy characterized by two barriers. This model derives some interesting results. First, the width of currency band depends positively on the uncertainty of the shock, the degree of speculative pressure, and central bank's concern about the domestic money market versus the foreign exchange market. Second, the central bank finds it optimal not to intervene when the fundamental rate is inside a certain band, whereas once it lies outside the band, the optimal policy is to move it to the nearest boundary. [F31]
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Volume (Year): 15 (2001)
Issue (Month): 1 ()
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