IDEAS home Printed from https://ideas.repec.org/p/fip/fedlwp/1994-009.html
   My bibliography  Save this paper

Endogenous realignments and the sustainability of a target

Author

Listed:
  • Dean Corbae
  • Christopher J. Neely
  • Paul A. Weller

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 that generates an increasing probability of realignment as output moves away from full employment. We find that for realistic parameter values, even relatively small misalignments of the currency 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 the existence of an equilibrium path for the exchange rate depends on the responsiveness of realignment expectations to economic fundamentals. Paradoxically, higher credibility may increase the probability that a target zone will collapse. This feature of the model provides a possible explanation for the crisis within the exchange rate mechanism of the EMS. A policy of monetary accommodation to real shocks can alleviate the problem but severely constrains a country?s ability to pursue counterinflationary measures within the band.

Suggested Citation

  • Dean Corbae & Christopher J. Neely & Paul A. Weller, 1998. "Endogenous realignments and the sustainability of a target," Working Papers 1994-009, Federal Reserve Bank of St. Louis.
  • Handle: RePEc:fip:fedlwp:1994-009
    as

    Download full text from publisher

    File URL: http://research.stlouisfed.org/wp/more/1994-009/
    Download Restriction: no

    File URL: http://research.stlouisfed.org/wp/1994/94-009.pdf
    Download Restriction: no

    References listed on IDEAS

    as
    1. Miller, Marcus & Weller, Paul, 1991. "Exchange Rate Bands with Price Inertia," Economic Journal, Royal Economic Society, vol. 101(409), pages 1380-1399, November.
    2. Mizrach, Bruce, 1995. "Target zone models with stochastic realignments: an econometric evaluation," Journal of International Money and Finance, Elsevier, vol. 14(5), pages 641-657, October.
    3. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
    4. Edin, Per-Anders & Vredin, Anders, 1993. "Devaluation Risk in Target Zones: Evidence from the Nordic Countries," Economic Journal, Royal Economic Society, vol. 103(416), pages 161-175, January.
    5. Miller, M. & Weller, P., 1988. "Exchange Rate Bands And Realignments In A Stationary Stochastic Setting," The Warwick Economics Research Paper Series (TWERPS) 317, University of Warwick, Department of Economics.
    6. Giuseppe Bertola & Lars E. O. Svensson, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," Review of Economic Studies, Oxford University Press, vol. 60(3), pages 689-712.
    7. Svensson, Lars E. O., 1992. "The foreign exchange risk premium in a target zone with devaluation risk," Journal of International Economics, Elsevier, vol. 33(1-2), pages 21-40, August.
    8. Clarida, Richard & Gali, Jordi, 1994. "Sources of real exchange-rate fluctuations: How important are nominal shocks?," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 41(1), pages 1-56, December.
    9. Malz, Allan M., 1996. "Using option prices to estimate realignment probabilities in the European Monetary System: the case of sterling-mark," Journal of International Money and Finance, Elsevier, vol. 15(5), pages 717-748, October.
    10. Paul R. Krugman, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, Oxford University Press, vol. 106(3), pages 669-682.
    11. Kenneth A. Froot & Kenneth Rogoff, 1991. "The EMS, the EMU, and the Transition to a Common Currency," NBER Chapters,in: NBER Macroeconomics Annual 1991, Volume 6, pages 269-328 National Bureau of Economic Research, Inc.
    12. Ghosh, Atish R & Masson, Paul R, 1991. "Model Uncertainty, Learning, and the Gains from Coordination," American Economic Review, American Economic Association, vol. 81(3), pages 465-479, June.
    13. Bertola, Giuseppe & Caballero, Ricardo J, 1992. "Target Zones and Realignments," American Economic Review, American Economic Association, vol. 82(3), pages 520-536, June.
    14. Miller, Marcus & Weller, Paul, 1995. "Stochastic saddlepoint systems Stabilization policy and the stock market," Journal of Economic Dynamics and Control, Elsevier, vol. 19(1-2), pages 279-302.
    15. Campa, Jose Manuel & Chang, P H Kevin, 1996. "Arbitrage-Based Tests of Target-Zone Credibility: Evidence from ERM Cross-Rate Options," American Economic Review, American Economic Association, vol. 86(4), pages 726-740, September.
    16. Sutherland, Alan, 1994. "Target Zone Models with Price Inertia: Solutions and Testable Implications," Economic Journal, Royal Economic Society, vol. 104(422), pages 96-112, January.
    17. Rose, Andrew K. & Svensson, Lars E. O., 1994. "European exchange rate credibility before the fall," European Economic Review, Elsevier, vol. 38(6), pages 1185-1216, June.
    18. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    19. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    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.

    More about this item

    Keywords

    Credit ; Foreign exchange rates;

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:fip:fedlwp:1994-009. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Kathy Cosgrove). General contact details of provider: http://edirc.repec.org/data/frbslus.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.