Working Paper: CEPR ID: DP1031
Authors: Marcus Miller; Lei Zhang
Abstract: Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.
Keywords: target zones; regulated brownian motion; time consistent policy; erm
JEL Codes: E42; F31; F33; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank intervention (E58) | exchange rate stability (F31) |
| narrower bands (F12) | welfare gains (D69) |
| precommitment to narrower bands (D79) | band width (L96) |