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Optimal Currency Target Zones: How Wide Should Exchange Rate Bands Be?

  • Joon-Hwan Im
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    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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    File URL: http://www.tandfonline.com/doi/abs/10.1080/10168730100000004
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    Article provided by Taylor & Francis Journals in its journal International Economic Journal.

    Volume (Year): 15 (2001)
    Issue (Month): 1 ()
    Pages: 61-93

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    Handle: RePEc:taf:intecj:v:15:y:2001:i:1:p:61-93
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    1. Kenneth A. Froot & Maurice Obstfeld, 1992. "Exchange Rate Dynamics Under Stochastic Regime Shifts: A Unified Approach," NBER Working Papers 2835, National Bureau of Economic Research, Inc.
    2. Svensson, Lars E. O., 1991. "Target zones and interest rate variability," Journal of International Economics, Elsevier, vol. 31(1-2), pages 27-54, August.
    3. Maurice Obstfeld, 1988. "The Effectiveness of Foreign-Exchange Intervention: Recent Experience," NBER Working Papers 2796, National Bureau of Economic Research, Inc.
    4. Miller, Marcus & Zhang, Lei, 1996. "Optimal target zones: How an exchange rate mechanism can improve upon discretion," Journal of Economic Dynamics and Control, Elsevier, vol. 20(9-10), pages 1641-1660.
    5. Stephen W. Salant & Dale W. Henderson, 1976. "Market anticipations, government policy, and the price of gold," International Finance Discussion Papers 81, Board of Governors of the Federal Reserve System (U.S.).
    6. Flood, Robert P & Garber, Peter M, 1991. "The Linkage between Speculative Attack and Target Zone Models of Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 106(4), pages 1367-72, November.
    7. Labhard, Vincent & Wyplosz, Charles, 1996. "The New EMS: Narrow Bands inside Deep Bands," American Economic Review, American Economic Association, vol. 86(2), pages 143-46, May.
    8. Salant, Stephen W, 1983. "The Vulnerability of Price Stabilization Schemes to Speculative Attack," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 1-38, February.
    9. Salant, Stephen W & Henderson, Dale W, 1978. "Market Anticipations of Government Policies and the Price of Gold," Journal of Political Economy, University of Chicago Press, vol. 86(4), pages 627-48, August.
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