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Endogenous Realignments and the Sustainability of a Target Zone

Author

Listed:
  • Corbae, P Dean
  • Neely, Christopher J
  • Weller, Paul

Abstract

We examine the effects of endogenously determined realignment expectations in a model of a target zone with sluggish price adjustment. We allow these expectations to be based on a policy rule which attaches differing weights to output and price stability. We find that for realistic parameter values even relatively small misalignments of the band lead to strongly skewed conditional distributions for the nominal exchange rate, thus generating pressures for realignment. We show that the reason for this is that the speed of adjustment in the absence of realignments is rather slow. Further, we find that variable realignment expectations impose tight limits on the width of a sustainable band. If realignment expectations reach quite moderate levels there no longer exists an intervention policy that will support the band. Finally, we show that even relatively infrequent realignments can substantially speed the process of adjustment to misalignment, casting doubt on the desirability of a policy designed to maintain a fully credible band in the face of significant external shocks.

Suggested Citation

  • Corbae, P Dean & Neely, Christopher J & Weller, Paul, 1995. "Endogenous Realignments and the Sustainability of a Target Zone," CEPR Discussion Papers 1253, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:1253
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    Citations

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    Cited by:

    1. Bernd Kempa & Michael Nelles, 1999. "Misalignments of real exchange rates and the credibility of nominal currency bands," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 135(4), pages 613-628, December.
    2. Yannacopoulos, Athanasios N., 2008. "Rational expectations models: An approach using forward-backward stochastic differential equations," Journal of Mathematical Economics, Elsevier, vol. 44(3-4), pages 251-276, February.

    More about this item

    Keywords

    European Monetary System; Realignments; Target Zones;

    JEL classification:

    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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