Exchange Rates
Monetary accommodation

Standard target zone models predict that the variability of the interest differential increases with the width of narrow currency bands but decreases for wider bands, and that the exchange rate is more likely to lie towards the edges of its band than in the centre. In classical models exchange rate bands do not improve welfare, but with sluggish nominal wages and transitory unemployment the central bank might usefully set monetary policy to accommodate wage and price shocks. In Discussion Paper No. 725, Roel Beetsma and Research Fellow Frederick van der Ploeg analyse the joint effects of monetary accommodation and currency bands on the exchange rate, interest rate, consumption price index, unemployment and output. They study a number of different exchange rate regimes: a dirty float (with a linear rule for monetary accommodation), a clean float, a PPP exchange rate rule, and pegged exchange rates where there is no exchange rate under- or overshooting in response to money supply shocks.

They find that a peg, a clean float and a PPP exchange rate rule are typically sub-optimal relative to a more general dirty float. The optimal degree of accommodation to price shocks is high when authorities care relatively more about full employment than price stability, and more flexible labour markets induce `right-wing' governments to move towards a cleaner float while `left-wing' governments move towards a PPP exchange rate rule.
In contrast to the theory's predictions, observations of EMS data since 1979 are strongly concentrated near the middle of the bands. Beetsma and van der Ploeg attribute these hump-shaped patterns to EMS countries engaging in interventions to stabilize exchange rates when the latter are within the hand as well as when they are at its edge. They conclude that it is hard to make a case for exchange rate bands on stabilization grounds alone, since the welfare loss can more effectively be reduced by a dirty float, but a welfare case for currency bands may be made on grounds of credibility.

Exchange Rate Bands and Optimal Monetary Accommodation Under a Dirty Float
Roel Beetsma and Frederick van der Ploeg

Discussion Paper No. 725, October 1992 (IM)