DP1123 On the Evolution of Credibility and Flexible Exchange Rate Target Zones

Author(s): Renzo Avesani, Giampiero M Gallo, Mark Salmon
Publication Date: February 1995
Keyword(s): Credibility, Dynamic Policy, Exchange Rate Target Zones, Flexibility, Incentive Compatability Sterilized Intervention, Signalling
JEL(s): F02, F31, F33, F36, F42
Programme Areas: International Macroeconomics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=1123

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.