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The Stabilizing Properties Of Target Zones

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  • MILLER, M.
  • WELLER, P.
  • WILLIAMSON, J.

Abstract

We examine the ability of a target zone to stabilize exchange rates in the presence of two stylised forms of market inefficiency - stochastic bubbles and "fads". We show how the usual saddlepath phase diagram is modified in the presence of bubbles (both where fundamentals are deterministic and where they are stochastic), and how a credible policy to defend a target zone prevents the emergence of any such bubbles. In the case of fads, we suppose that the source of shocks driving the exchange rate from its long-run equilibrium level is the fluctuating sentiment of "noise traders". The presence of "smart money" in the market exerts a stabilizing influence upon the exchange rate even in the absence of a target zone. In the presence of a fully credible target zone, where the authorities can take the necessary actions to check the swings in market sentiment, we use results on regulated Brownian motion to characterise the exchange rate trajectory, and demonstrate that the stabilizing influence of "smart money" is increased.
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Suggested Citation

  • Miller, M. & Weller, P. & Williamson, J., 1989. "The Stabilizing Properties Of Target Zones," The Warwick Economics Research Paper Series (TWERPS) 318, University of Warwick, Department of Economics.
  • Handle: RePEc:wrk:warwec:318
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    File URL: https://warwick.ac.uk/fac/soc/economics/research/workingpapers/1989-1994/twerp318.pdf
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    References listed on IDEAS

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    1. Miller, Marcus & Weller, Paul, 1988. "Solving Stochastic Saddlepoint Systems: A Qualitative Treatment With Economic Applications," Economic Research Papers 268343, University of Warwick - Department of Economics.
    2. Flood, Robert P & Hodrick, Robert J, 1986. "Asset Price Volatility, Bubbles, and Process Switching," Journal of Finance, American Finance Association, vol. 41(4), pages 831-842, September.
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    5. Currie, David & Wren-Lewis, Simon, 1990. "Evaluating the Extended Target Zone Proposal for the G3," Economic Journal, Royal Economic Society, vol. 100(399), pages 105-123, March.
    6. Marcus H. Miller & John Williamson, 1991. "The International Monetary System: An Analysis of Alternative Regimes," NBER Chapters, in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 279-302, National Bureau of Economic Research, Inc.
    7. De Long, J Bradford & Shleifer, Andrei & Summers, Lawrence H & Waldmann, Robert J, 1991. "The Survival of Noise Traders in Financial Markets," The Journal of Business, University of Chicago Press, vol. 64(1), pages 1-19, January.
    8. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-1181, September.
    9. Paul R. Krugman, 1985. "Is the strong dollar sustainable?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 103-155.
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    11. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    12. John Y. Campbell & Albert S. Kyle, 1993. "Smart Money, Noise Trading and Stock Price Behaviour," Review of Economic Studies, Oxford University Press, vol. 60(1), pages 1-34.
    13. Edison, Hali J. & Miller, Marcus H. & Williamson, John, 1987. "On evaluating and extending the target zone proposal," Journal of Policy Modeling, Elsevier, vol. 9(1), pages 199-224.
    14. Gregor W. Smith, 1987. "Apparent Bubbles and Misspecified Fundamentals," Working Paper 692, Economics Department, Queen's University.
    15. Kenneth D. West, 1988. "Bubbles, Fads, and Stock Price Volatility Tests: A Partial Evaluation," NBER Working Papers 2574, National Bureau of Economic Research, Inc.
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    Cited by:

    1. Leech, Dennis, 1990. "Power Indices and Probabilistic Voting Assumptions," Public Choice, Springer, vol. 66(3), pages 293-299, September.
    2. Leech, Dennis, 1989. "Power Indices And Probabilistic Voting Assumptions," Economic Research Papers 268359, University of Warwick - Department of Economics.
    3. Ikeda, Shinsuke & Shibata, Akihisa, 1995. "Fundamentals uncertainty, bubbles, and exchange rate dynamics," Journal of International Economics, Elsevier, vol. 38(3-4), pages 199-222, May.

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