The substantial literature on exchange rate target zones has devoted relatively little effort to the rationale for their existence, which have increasingly been called into question by recent events in the European Monetary System. Furthermore, virtually no attention has been paid to their effects on stabilization policy, since standard classical models assume full employment and flexible prices. In Discussion Paper No. 925, Roel Beetsma and Research Fellow Frederick van der Ploeg develop a model of nominal exchange rate bands under a variety of shocks which allows sluggish wage/price adjustment, which they use to analyse optimal monetary policy to stabilize output and prices in the face of shocks to goods demand, money demand and supply.

They first show that the optimal responses under an unrestricted dirty float are nominal income targeting for goods demand shocks and a fixed exchange rate for money demand shocks, while that for stagflationary supply shocks depends on the relative weights attached to price stability and employment. In terms of its stabilization properties, an exchange rate band can be seen as a combination of such a float with a fixed rate, whose stabilizing properties increasingly resemble those of a fixed rate as the band narrows or the variance of shocks increases. In a first-best world hit by goods demand and supply shocks, such a band induces welfare losses when the authorities have to switch to a peg in order to defend the exchange rate at its boundaries; but no such losses arise from shocks to money demand, since the authorities then keep the exchange rate at its central parity. Bands are therefore difficult to rationalize in relation to macroeconomic stabilization policy. In a second-best world, however, where monetary accommodation is restricted, for example by a multilateral exchange rate arrangement that takes priority over a national rule, an exchange rate band may be desirable if shocks to money demand dominate, or if supply shocks dominate and the authorities attach a high weight to output stability.

Macroeconomic Stabilization and Intervention Policy Under an Exchange Rate Band
Roel M W J Beetsma and Frederick van der Ploeg

Discussion Paper No. 925, March 1994 (IM)