How Tight Should One's Hands Be Tied? Fear of Floating and Credibility of Exchange Rate Regimes

Jesús Rodríguez López and Hugo Rodríguez Mendizábal
Authors registered in the RePEc Author Service: Hugo Rodriguez Mendizabal and Jesús Rodríguez-López (jrodlop@upo.es)

No 96, Working Papers from Barcelona School of Economics

Abstract: This paper analyzes the linkages between the credibility of a target zone regime, the volatility of the exchange rate, and the width of the band where the exchange rate is allowed to fluctuate. These three concepts should be related since the band width induces a trade-off between credibility and volatility. Narrower bands should give less scope for the exchange rate to fluctuate but may make agents perceive a larger probability of realignment which by itself should increase the volatility of the exchange rate. We build a model where this trade-off is made explicit. The model is used to understand the reduction in volatility experienced by most EMS countries after their target zones were widened on August 1993. As a natural extension, the model also rationalizes the existence of non-official, implicit target zones (or fear of floating), suggested by some authors.

Keywords: Target zones; Fear of floating; exchange rate arrangements; rational expectations; credibility (search for similar items in EconPapers)
JEL-codes: E52 E58 F31 F33 (search for similar items in EconPapers)
Date: 2015-09
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Related works:
Journal Article: How Tight Should One's Hands be Tied? Fear of Floating and the Credibility of Exchange Rate Regimes (2006)
Working Paper: How tight should one's hands be tied? Fear of floating and credibility of exchange rate regimes (2003)
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