`Fixed' exchange rates are in practice adjusted by discrete, periodic realignments, between which they also fluctuate within bands around their central parities. In Discussion Paper No. 742, Research Fellow Lars Svensson develops a formal model of a small open economy with free international capital mobility. The domestic interest rate must equal the sum of the foreign interest rate, the expected rate of currency depreciation (which can be decomposed into the expected rates of change of the central parity and of depreciation within the band), and the foreign exchange risk premium. With the exchange rate initially at its central parity and the expected rate of depreciation zero, the central bank can reduce the domestic interest rate to allow an incipient capital outflow but need not intervene to prevent a depreciation. The exchange rate rises until its expected rate of depreciation within the band matches the initial fall in the domestic interest rate.

This monetary `independence' is clearly limited, since the band width restricts the magnitude of depreciation. Moreover, it applies only to short maturities and falls further if deviations from the central parity induce realignment expectations. Nevertheless, central banks retain some freedom (which increases with the band width) to stabilize output and inflation or dampen the domestic effects of changes in foreign interest rates or the expected rate of realignment.

Svensson quantifies monetary independence by focusing on the ability to smooth domestic interest rates. For Swedish data for 1986-92, he shows that its influence on short-term domestic interest rates may be sizeable: raising the band width from zero to 2% roughly halves the one-month interest rate's standard deviation. He also simulates various optimal intervention policies and compares the resulting exchange and interest rates with observed behaviour. Finally, he warns that the effects of exploiting such monetary independence may be quite small. Recent experience in Austria, Belgium and the Netherlands, which have all pegged their currencies very closely to the Deutschmark, suggests that there may also be gains to credibility from not exploiting the monetary independence exchange rate bands afford.

Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates
Lars E O Svensson

Discussion Paper No. 742, December 1992 (IM)