Working Paper: CEPR ID: DP1123
Authors: Renzo G. Avesani; Giampiero M. Gallo; Mark Salmon
Abstract: This paper considers a new approach to the optimal management and analysis of exchange rate target zones by regarding the operation of a target zone as a dynamic signalling game between the monetary authorities and the financial markets. A Sequential Open Loop (Feedback) policy of sterilized intervention is proposed that depends critically on the evolution of the policy-maker's credibility as opposed to the open loop precommitment strategy that has been implemented, for instance, in the Exchange Rate Mechanism of the EMS and in the Bretton Woods system. The width of the target zone and realignments are in turn determined optimally given the policy-maker's credibility. A commitment to this form of flexible target zone is shown through simulation to provide substantial stabilization for the exchange rate while retaining considerable flexibility and robustness in response to shocks.
Keywords: exchange rate target zones; credibility; flexibility; incentive compatibility; sterilized intervention; signalling; dynamic policy games
JEL Codes: F02; F31; F33; F36; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher credibility (D81) | wider target zone (E61) |
| wider target zone (E61) | stabilize exchange rate (F31) |
| higher credibility (D81) | effectiveness of sterilized interventions (C90) |
| credibility (D83) | success of intervention strategies (I24) |
| credibility (D83) | alignment of expected exchange rate with target zone (F31) |
| strategic response of policymakers (E60) | mitigate likelihood of speculative attacks (D84) |
| credibility (D83) | resilience of exchange rate system (F31) |