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Title: Exchange Rate Bands and Optimal Monetary Accommodation Under a Dirty Float

Author(s): Roel Beetsma and Frederick van der Ploeg

Publication Date: October 1992

Keyword(s): Brownian Motion, Dirty Floating, Exchange Rate Regimes, PPP Exchange Rate Rules, Stochastic Simulation and Supply Shocks

Programme Area(s): International Macroeconomics

Abstract: This paper studies regimes of managed exchange rates for a small open economy with an integrated capital market, rational expectations in financial markets, sluggish nominal wages and prices, and supply shocks that follow a Brownian motion. Each regime can be characterized by the degree to which price shocks are accommodated and the width of the exchange rate band. Special cases of monetary accommodation are a peg, a clean float and a PPP exchange rate rule. First, the optimal degree of monetary accommodation of price shocks is analysed when there is no exchange rate band. Given that the welfare loss is a weighted sum of the asymptotic variances of output and of consumer prices, monetary accommodation is particularly strong when the authorities care relatively more about full employment than price stability. More flexible labour markets induce right-wing governments to move towards a cleaner float and left-wing governments towards a PPP exchange rate rule. Second, the effects of exchange rate bands and the accompanying inframarginal interventions are examined when allowance is made for intramarginal interventions as well. Such a framework can, in contrast to the pioneering Krugman analysis, explain the observed hump-shaped unconditional density functions of EMS exchange rates.

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Bibliographic Reference

Beetsma, R and van der Ploeg, F. 1992. 'Exchange Rate Bands and Optimal Monetary Accommodation Under a Dirty Float'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=725