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In recent research, Paul Krugman has derived an explicit analytical solution for the path of the exchange rate within a currency band under rational expectations, assuming that the velocity of money follows a particular kind of stochastic process, `Brownian motion'. Krugman's work makes use of a monetary model of exchange rate determination, which treats the exchange rate entirely as a financial asset and disregards real variables, assuming perfect price flexibility, full employment and purchasing power parity. Extensions of this research have been reported in CEPR Discussion Paper Nos. 299, 308, 361 and 372.In Discussion Paper No. 382, Programme Director Marcus Miller and Research Fellow Paul Weller explore similar `stochastic switching processes' in a variant of Dornbusch's alternative `overshooting' exchange rate model. This describes the dynamic behaviour of output and the real exchange rate, and allows consideration of real as well as nominal exchange rate bands. This is an advantage in the light of the Miller-Williamson proposals for real exchange rate `target zones'. Miller and Weller analyse exchange rate behaviour in a model with rational expectations and random shocks to domestic prices. The cost of having the fundamental variable, the domestic price level, follow an autoregressive process determined within the model is that explicit analytical solutions are no longer available. The authors are able, however, to provide a complete qualitative characterization of the behaviour of the exchange rate in both a nominal and a real band. The intervention policies required of the monetary authorities to defend a real band are very different from those required for a nominal band. In a nominal band, periodic realignments triggered when the rate hits an upper or lower limit require discrete adjustments in the money stock to equalize domestic and foreign interest rates. These bear a close formal similarity to the `smooth pasting' condition identified in earlier work using the monetary model, according to Miller and Weller, though the reasons for imposing the condition are rather different. When the adjustments are made, the exchange rate lingers temporarily on the edge of the band, requiring any further divergent price shocks to be met with partial monetary accommodations. Enforcing a real target zone requires the authorities to focus on the relationship between real balances and the real exchange rate, using monetary intervention to check the real interest rate when the exchange rate hits the limits of the band. The exchange rate remains only for an instant at the edge of the real band, so it is less onerous for the authorities to support. Depending on parameter values, however, there may exist a second solution path with an unstable exchange rate trajectory, necessitating intervention within the margins to keep the market away from such a trajectory. Miller and Weller also analyse the use of fiscal adjustments to augment monetary policy in limiting exchange rate variability. They focus on a cash limit on government spending triggered by a critical level of the trade deficit. State-contingent fiscal rules used in this way may help either to reduce the pressure on monetary policy under a free float or to enhance the credibility of policy where the float is limited by currency bands Currency Bands, Target Zones, and Cash Limits:Thresholds for Monetary and Fiscal Policy Marcus Miller and Paul Weller Discussion Paper No. 382, March 1990 (IM) |