Working Paper: CEPR ID: DP421
Authors: Marcus Miller; Paul Weller
Abstract: We formulate a stochastic, rational-expectations model of exchange rate determination, in which there are random shocks to the process of sluggish price adjustment. We examine the effects of imposing limits upon the range of variation of both nominal and real exchange rates and describe the intervention policies needed to defend the bands in each case. We consider the possibility that commitment to defend a particular nominal band may be less than fully credible, and we analyse the implications of operating certain rules for realignment. We contrast our results with those which arise in the Krugman model of a nominal band.
Keywords: price inertia; target zones; currency bands; realignments; stochastic process; switching
JEL Codes: 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Imposing a real currency band (F33) | Stabilizes the real exchange rate (F31) |
| Stabilizes the real exchange rate (F31) | Reduced variability in response to economic shocks (E39) |
| The credibility of the nominal band (E51) | Necessity for intervention (H84) |
| Less credible nominal band (E32) | Expectations of realignment (D84) |
| Intervention policies (H53) | Influence market interest rates (E43) |
| Market interest rates (E43) | Affect exchange rate stability (F31) |
| Likelihood of realignment (D79) | Influences market behavior and expectations (D84) |
| Market expectations about future policy actions (E60) | Affect current exchange rate movements (F31) |