DP1031 Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion

Author(s): Marcus Miller, Lei Zhang
Publication Date: October 1994
Keyword(s): ERM, Regulated Brownian Motion, Target Zones, Time Consistent Policy
JEL(s): E42, F31, F33, F42
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=1031

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.