In Discussion Paper No. 1123, Renzo Avesani, Giampiero Gallo and Research Fellow Mark Salmon examine the optimal management of exchange rate target zones by considering, formally, how partial credibility may be modelled and incorporated into the existing analysis. In doing so, they regard the operation of a target zone as a dynamic signalling game between the monetary authorities and the financial markets.

The authors propose a `sequential open loop (feedback)' policy of sterilized intervention 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.

On the Evolution of Credibility and Flexible Exchange Rate Target Zones
Renzo G Avesani, Giampiero M Gallo and Mark Salmon

Discussion Paper No. 1123, February 1995 (IM)