Exchange Rate Targeting and Economic Stabilization

In this paper, we investigate the effects of increasing exchange rate flexibility at the margin instead of comparing the polar regimes of fixed and flexible rates. A VAR model with a structural analysis of the financial sector, including exchange rate intervention, is set up for a set of five major industrial countries and estimated using monthly data from the post-Bretton Woods period. IRFs suggest that in most countries intervention appears to be effective, although responses seem very short-lived, lasting just a few months. Counterfactual experiments are undertaken in which the central bank limits exchange rate fluctuations within a prescribed band. Varying the bandwidths shows that the only variable that systematically changes is foreign reserves, which become more volatile with a narrower band. Greater exchange rate flexibility obtained through wider bands neither increases nor decreases volatilities in the interest rate, output, or inflation for the majority of cases. Our results suggest that exchange rate stability is not necessarily earned at the cost of sacrificing interest rate stability and thereby support the idea that stable exchange rates can be welfare improving from a purely domestic point of view and for countries with heavy external debt