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Title: On the Evolution of Credibility and Flexible Exchange Rate Target Zones

Author(s): Renzo Avesani, Giampiero M Gallo and Mark Salmon

Publication Date: February 1995

Keyword(s): Credibility, Dynamic Policy, Exchange Rate Target Zones, Flexibility, Incentive Compatability Sterilized Intervention and Signalling

Programme Area(s): International Macroeconomics

Abstract: 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.

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Bibliographic Reference

Avesani, R, Gallo, G and Salmon, M. 1995. 'On the Evolution of Credibility and Flexible Exchange Rate Target Zones'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=1123