Working Paper: CEPR ID: DP1253
Authors: Christopher J. Neely; Paul A. Weller; P. Dean Corbae
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 which attaches differing weights to output and price stability. We find that for realistic parameter values even relatively small misalignments of the 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 variable realignment expectations impose tight limits on the width of a sustainable band. If realignment expectations reach quite moderate levels there no longer exists an intervention policy that will support the band. Finally, we show that even relatively infrequent realignments can substantially speed the process of adjustment to misalignment, casting doubt on the desirability of a policy designed to maintain a fully credible band in the face of significant external shocks.
Keywords: target zones; realignments; european monetary system
JEL Codes: E58; F31; F33; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| band misalignment (Y50) | pressures for realignment (D74) |
| realignment expectations (D84) | sustainability of the band (Q01) |
| realignment actions (D79) | adjustment process (F32) |