The Nordic countries, Chile, Israel and Mexico have recently adopted unilateral exchange rate bands, and many LDCs and former socialist economies may do likewise. Such a commitment requires important choices about the band width, the frequency and form of realignments, the method of intervention and the central parity, but the recent voluminous literature on currency bands has largely taken their existence and width as exogenous and cannot account for policy changes such as the widening of bands in the ERM. In Discussion Paper No. 907, Alex Cukierman, Miguel Kiguel and Research Fellow Leonardo Leiderman develop a model of such bands as outcomes of an optimization problem for policy-makers who weigh the level of the real exchange rate against the level and variability of the nominal rate. For countries concerned to preserve and improve their competitiveness and current accounts while avoiding the inflationary consequences of a nominal depreciation, such bands provide a simple, verifiable means of making a credible commitment while retaining enough flexibility to shield exports and the current account from adverse shocks. By endogenizing decisions about the band width and realignments, this framework allows the authors to identify the conditions under which reneging on the commitment and setting a new set of band parameters is the optimal response to shocks.

The determination of band width entails a trade-off between credibility and flexibility. The authors identify conditions under which the optimal band width widens if there is an increase in policy-makers' reputation, the cost of reneging or the variance of the fundamentals. The band's existence usually has a moderating influence on the variability of expected currency depreciation, whose strength increases with policy-makers' reputation and the cost of reneging. The authors use their model to discuss the band's credibility and its dependence on policy-makers' reputation, the cost of reneging and the position of the exchange rate within the band. The contribution of expected realignments to expected depreciation increases as the exchange rate rises towards the band's upper bound.

Choosing the Width of Exchange Rate Bands Credibility vs. Flexibility
Alex Cukierman, Miguel A Kiguel and Leonardo Leiderman

Discussion Paper No. 907, January 1994 (IM)