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Title: Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion

Author(s): Marcus Miller and Lei Zhang

Publication Date: October 1994

Keyword(s): ERM, Regulated Brownian Motion, Target Zones and Time Consistent Policy

Programme Area(s): International Macroeconomics

Abstract: Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.

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Bibliographic Reference

Miller, M and Zhang, L. 1994. 'Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=1031