Discussion paper

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

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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Citation

Miller, M (1994), “DP1031 Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion”, CEPR Press Discussion Paper No. 1031. https://cepr.org/publications/dp1031