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.