Exchange Rate Target Zones
Fiscal Stabilization Needed

Since the breakdown of the Bretton Woods system of fixed exchange rates, many schemes have been proposed for a new, more structured world monetary system. The search has been intensified after the recent sustained misalignment of the United States dollar which, after rising sharply in the early 1980s, remained overvalued for a number of years before it eventually fell equally sharply after 1985. Despite this fall the United States trade deficit, which increased dramatically during the strong dollar years, showed few signs of improvement between 1985 and 1987, intensifying pressures for protectionist legislation in the United States.
One of the most influential of the recent suggestions for reform of world monetary arrangements is John Williamson's (1985) proposal for a system of target zones for exchange rates. According to this proposal, the main industrial economies should arrange for regular meetings that would fix central target parities for their exchange rates, in accordance with economic fundamentals. This would avoid the large persistent misalignments witnessed in the 1970s and the early 1980s. Between meetings, currencies would be allowed to float within a target zone around the central parities, and individual economies should use fiscal policy to achieve internal objectives and monetary policy to keep their exchange rate within their target zone. In his elaboration of the target zone proposal, Williamson (1986, 1987) is very careful to distinguish it from a fixed exchange rate regime. To quote, the guidance to expectations provided by a credible target zone plus exchange market intervention plus the wide band will allow significant scope for interest rate differentials to fluctuate with regard to the needs of domestic stabilization. That may well be sufficient to avoid the anti-cyclical fiscal policy... (Williamson (1987) p.204).
Other experts on international finance are less optimistic. Dornbusch (1986), for example, notes that, as long as legislatures or administrations reserve the privilege of enacting extravagant fiscal policies, market prices from exchange rates to interest rates will adjust; fixing some will quite possibly make others move even more. Accommodating a poor fiscal policy by exchange rate-oriented monetary policy simply adds yet another folly. (p.222) This point is reiterated by Frenkel (1987), who notes that, as long as fiscal policies are misaligned, a `successful' targeting of the exchange rate by using monetary policies may exacerbate the departures from the optimal mix of fiscal and monetary policies and may be very costly in terms of the overall economic system. (p.208) So far, the performance of target zones has been assessed only empirically, by Edison, Miller and Williamson (1987), who used the MCM model of the Federal Reserve Board. They concluded that a target zone, aided by fiscal policy, would have performed in a very satisfactory way in the post-1976 period.
In this paper I put forward a theoretical analysis of the issues raised by the target zone proposal, and compare the performance of optimal policies for world stabilization with a regime of target zones, in which individual economies are allowed to pursue their internal objectives independently.
I assume that all economies produce both traded and non-traded goods, and that they have a similar structure. In accordance with the basic premise of the target zones proposal, I also assume that apart from dealing with unanticipated transitory disturbances, all economies have agreed on real exchange rates consistent with economic fundamentals. All variables in the model can therefore be expressed as transitory deviations from their long-run equilibrium values, which for simplicity are assumed constant. I also assume that for all countries, nominal wages have been set at the same time as the exchange rate target zones, before the realization of the current unanticipated disturbances to the world economy. Following Gray (1976), Fischer (1977) and Taylor (1979), I assume that nominal wages are imperfectly indexed to the price level. Thus, unless the authorities can follow an appropriate stabilization policy, the unanticipated disturbances impose welfare losses that stem from this labour market imperfection. I use Aizenman and Frenkel's measure of this welfare loss, which is a Harberger triangle for the labour market. One of the innovations of this paper, however, is that I combine this measure with a Bailey (1956) triangle, which measures the welfare loss in the money market induced by the fact that unanticipated disturbances may cause nominal interest rates to deviate from their long-run equilibrium value. I thus model the policy authorities as having to minimize a weighted average of the welfare cost of unemployment (the Harberger triangle in the labour market) and the welfare cost of monetary instability (the Bailey triangle in the money market). These measures have microeconomic foundations as firm as in any model where the starting point is demand and supply functions.
If countries have recourse to both monetary and fiscal policy, first-best policies are available and the welfare loss due to aggregate fluctuations can be completely eliminated. If countries are unable to use fiscal policy, a second-best outcome results. Welfare is reduced, although the loss is minimized in the sense that the marginal cost of more unemployment equals the marginal cost of less monetary instability. This is not too surprising, as each country tries to achieve two internal objectives with one policy instrument (monetary policy in this case).
The analysis also suggests that the effects of policies on welfare are sensitive to assumptions concerning the world economy. I consider two possibilities: a competitive world economy where all countries are small, and a world economy in which one country is significantly larger than the others and acts as a Stackelberg leader.
If all countries are prepared to use both monetary and fiscal policy for stabilization purposes, then the first-best outcome can be achieved through a world monetary regime of fixed exchange rates, in which domestic fiscal policy is assigned to the unemployment objective and either world monetary policy or the Stackelberg leader's monetary policy is assigned to the monetary stability objective. Such an assignment results in complete elimination of the welfare cost of aggregate fluctuations for all countries. Such a system has all the essentials of the target zone proposal, and most of those of the Bretton Woods system as well.
On the other hand, if no country is willing to use fiscal policy actively for stabilization purposes, then the optimal (but second-best) world monetary arrangement would be to assign world monetary policy to minimize the welfare loss caused by the shocks to supply and demand at the global level, while leaving the distribution of the world money stock to the national authorities. The latter will minimize, through unsterilized exchange market interventions, the welfare losses caused by the national components of supply and demand shocks. World monetary policy could be operated through either a world monetary authority or the monetary authorities of the Stackelberg leader.
Finally, if the only economy constrained in its use of fiscal policy is the Stackelberg leader, then the best possible world monetary arrangement in these circumstances is again second-best. The only loser is the constrained leader in this case. The smaller economies completely eliminate their own welfare losses due to fluctuations at the global level by using their fiscal policies to eliminate the welfare cost of unemployment and using their monetary policy to keep their nominal interest rates at their long-run equilibrium values. This is done by appreciating (depreciating) against the leader's currency by a proportion equal to the deviation of the leader's current interest rate from its long-run equilibrium value.
In a world in which first-best policies are available, target zones are clearly the optimal arrangement. It is easy to show that the first-order conditions for a global optimum coincide with the conditions for individual countries. In addition international liquidity must be such as to keep deviations of the world nominal interest rate at their optimal level. Thus, the optimal assignment is to have an international monetary authority that will undertake the task of minimizing the average money market distortion by supplying the optimal amount of liquidity, and to leave the distribution of liquidity and the employment objective to the individual countries. With the world nominal interest rate held constant at its long-run level, individual countries will opt for fixed exchange rates. With fiscal policy in individual countries set optimally, the employment objective is also achieved, and all real variables are at their competitive equilibrium values
Thus in a competitive world economy the essentials of the target zone proposal, i.e. relatively fixed exchange rates and fiscal policy independence, ensure the first-best optimum. One could therefore conclude that in such a world this is the optimal monetary arrangement. In the case of a Stackelberg leader, equilibrium coincides with the competitive outcome. Again, the essentials of the target zone proposal (i.e. fix exchange rates, let small countries run their own fiscal policy, and let the Stackelberg leader fix the world money supply) are equivalent to the first-best outcome.
In a second-best world, if relative supply and demand shocks have a sufficiently large variance, the existence of bands might hinder rather than promote the minimization of the welfare loss of aggregate fluctuations by individual countries. Target zones with soft buffers might be better in this respect, but in such a case it is not clear whether formal target zones have any advantages over and above the system that emerged after the Plaza Agreement of 1985. The guide to expectations argument holds for the post-Plaza system just as well. On the other hand, if the only country that is constrained in its use of fiscal policy is the Stackelberg leader, a target zone with bands as wide as those suggested by Williamson (1987) might not be too far from the optimal world monetary system. In such a case, the optimal degree of exchange rate swings is equal to the deviation of the leader's interest rate from its long-run equilibrium value. Swings of nominal interest rates of more than 10% are not observed for the main industrial economies.