Working Paper: NBER ID: w2481
Authors: Paul R. Krugman
Abstract: This paper develops a highly simplified model of exchange rate behavior within the band under a target zone regime. It shows that the expectation that authorities will defend the band exerts a stabilizing effect on exchange rate behavior within the band, even when the authorities are not actively intervening. The extent of stabilization can be related in a straightforward way to three factors: the sensitivity of the current exchange rate to expected depreciation, the volatility of the process driving exchange rate "fundamentals", and the credibility of the commitment by authorities to defend the target zone.
Keywords: exchange rates; target zones; monetary policy
JEL Codes: F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Expectation of authorities defending target zone (E61) | Stabilizing effect on exchange rate behavior (F31) |
| Exchange rate behavior (F31) | Influenced by fundamentals and expected changes in exchange rate (F31) |
| Authorities' commitment to maintain exchange rate within target zone (F33) | Relationship between exchange rate and fundamentals (F31) |
| Approaching edges of the band (Y20) | Reduced volatility compared to freely floating exchange rate (F31) |
| Sensitivity of exchange rate to expected depreciation (F31) | Stabilizing effect (E63) |
| Volatility of fundamentals (G17) | Stabilizing effect (E63) |
| Credibility of government's commitment to defend target zone (E61) | Stabilizing effect (E63) |