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Exchange Rate Bands and Optimal Monetary Accommodation Under a Dirty Float



This paper studies regimes of managed exchange rates for a small open economy with an integrated capital market, rational expectations in financial markets, sluggish nominal wages and prices, and supply shocks that follow a Brownian motion. Each regime can be characterized by the degree to which price shocks are accommodated and the width of the exchange rate band. Special cases of monetary accommodation are a peg, a clean float and a PPP exchange rate rule. First, the optimal degree of monetary accommodation of price shocks is analysed when there is no exchange rate band. Given that the welfare loss is a weighted sum of the asymptotic variances of output and of consumer prices, monetary accommodation is particularly strong when the authorities care relatively more about full employment than price stability. More flexible labour markets induce right-wing governments to move towards a cleaner float and left-wing governments towards a PPP exchange rate rule. Second, the effects of exchange rate bands and the accompanying inframarginal interventions are examined when allowance is made for intramarginal interventions as well. Such a framework can, in contrast to the pioneering Krugman analysis, explain the observed hump-shaped unconditional density functions of EMS exchange rates.

Suggested Citation

  • Beetsma, Roel & van der Ploeg, Frederick, 1992. "Exchange Rate Bands and Optimal Monetary Accommodation Under a Dirty Float," CEPR Discussion Papers 725, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:725

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    References listed on IDEAS

    1. Grandmont, Jean-Michel, 1978. "Intermediate Preferences and the Majority Rule," Econometrica, Econometric Society, vol. 46(2), pages 317-330, March.
    2. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
    3. Bureau, Dominique & Champsaur, Paul, 1992. "Fiscal Federalism and European Economic Unification," American Economic Review, American Economic Association, vol. 82(2), pages 88-92, May.
    4. Tabellini, Guido & Alesina, Alberto, 1990. "Voting on the Budget Deficit," American Economic Review, American Economic Association, vol. 80(1), pages 37-49, March.
    5. Xavier Sala-i-Martin & Jeffrey Sachs, 1991. "Fiscal Federalism and Optimum Currency Areas: Evidence for Europe From the United States," NBER Working Papers 3855, National Bureau of Economic Research, Inc.
    6. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-1190, September.
    7. Wildasin, David E, 1990. "Budgetary Pressures in the EEC: A Fiscal Federalism Perspective," American Economic Review, American Economic Association, vol. 80(2), pages 69-74, May.
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    Cited by:

    1. Sutherland, Alan, 1995. "Monetary and real shocks and the optimal target zone," European Economic Review, Elsevier, vol. 39(1), pages 161-172, January.
    2. E.O. Svensson, Lars, 1994. "Why exchange rate bands? : Monetary independence in spite of fixed exchange rates," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 157-199, February.
    3. Beetsma, Roel M W J & van der Ploeg, Frederick, 1994. "Intramarginal Interventions, Bands and the Pattern of EMS Exchange Rate Distributions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 35(3), pages 583-602, August.
    4. Daniel Laskar, 1997. ""Incohérence temporelle" de la politique monétaire optimale. Un argument en faveur des zones cibles," Revue Économique, Programme National Persée, vol. 48(1), pages 5-22.
    5. Bekaert, Geert & Gray, Stephen F., 1998. "Target zones and exchange rates:: An empirical investigation," Journal of International Economics, Elsevier, vol. 45(1), pages 1-35, June.
    6. BESSEC Marie, "undated". "The Asymmetric Exchange Rate Dynamics in the EMS: a Time-Varying Threshold Test," EcoMod2003 330700015, EcoMod.

    More about this item


    Brownian Motion; Dirty Floating; Exchange Rate Regimes; PPP Exchange Rate Rules; Stochastic Simulation; Supply Shocks;

    JEL classification:

    • E0 - Macroeconomics and Monetary Economics - - General
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance


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