Working Paper: NBER ID: w0527
Authors: William H. Branson; Jorge Braga de Macedo
Abstract: This paper derives optimal weights for current-account and reserve indicators for adjusting the exchange rate (a "crawling peg"). Keven (1975)showed that use of a current account indicator alone would not stabi1iereserves, while a reserve indicator results in unstable fluctuations in the exchange rate. This paper begins by analyzing the problem in the frame work of Phillips (1954), in which the current account indicator is "proportional" and the reserve indicator is "integral." We then analyze the problem in a deterministic optimal control framework, and finally as a problem in stochastic control. In all cases the optimal combination is a weighted average, which we call the Keven-Phillips formula. With a fairly low variance of the current account, its weight falls in the range 0.47-0.65. Rising variance reduces its weight in the optimal formula.
Keywords: exchange rate; crawling peg; optimal control; current account; reserve indicators
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| current account indicator (F32) | reserve stability (E63) |
| reserve indicator (Q20) | exchange rate fluctuations (F31) |
| optimal combination of indicators (Kenen-Phillips formula) (C43) | weight of current account (F32) |
| variance of current account (F32) | weight of current account (F32) |
| choice of indicators (C43) | stability of exchange rate (F31) |
| correlation between disturbances (C10) | optimal control rule (C61) |