The literature on ‘target zone’ exchange-rate systems hitherto has focused only on the bilateral case, for which some well-known results have been obtained. In Discussion Paper No. 1504, Marc Flandreau considers the more general – and more policy-relevant – multilateral case of several coexisting target zones, and finds the earlier results must be substantially modified. The intuitive explanation is that interventions to stabilize one exchange rate influence the other rates.

There are several key findings. First, these ‘externalities’ mean that the exact ways in which interventions are conducted are no longer irrelevant. Second, intra-marginal interventions – exogenous in the two-currency case – now become endogenous. Indeed, virtually all interventions now become intra-marginal – a fact often observed in practice, e.g. in the EMS. Third, the inherently stabilizing ‘honeymoon’ and ‘smooth-pasting’ effects of fluctuation zones are enhanced. The main policy implication is that monetary authorities have to define not only the central parities and fluctuation bands, but also the intervention rules and stabilization procedures. The externalities problem can be mitigated, however, if there is a hegemonic ‘centre’ country large enough to insulate each ‘peripheral’ country from the consequences of any given intervention. In the absence of a hegemon, the full thrust of the externalities will cause the effective fluctuation zone to be narrower than the nominal band, thus reducing national monetary independence. As the number of participating countries increases, therefore, flexibility requires broadening, not narrowing, of the target zones – the exact opposite of the ‘Stage II’ proposals for the EMS.

The Burden of Intervention: Externalities in Multilateral Exchange Rate Arrangements
Marc Flandreau