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Optimal Target Zones: How an Exchange Rate Mechanism Can Improve Upon Discretion

Marcus Miller () and Lei Zhang
Authors registered in the RePEc Author Service: Lei Zhang () and Lei Zhang ()

No 1031, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: Using Krugman's (1991) target zone model, we find an explicit, sub-game perfect solution for a central bank wishing to stabilize the exchange rate given proportional costs of intervention. We demonstrate, however, that precommitment to narrower bands would yield a welfare gain - which provides a theoretical rationale for an Exchange Rate Mechansim (ERM). Numerical simulations suggest that the optimal currency band with precommitment via an ERM is only half as wide as that under discretion.

Keywords: ERM; Regulated Brownian Motion; Target Zones; Time Consistent Policy (search for similar items in EconPapers)
JEL-codes: E42 F31 F33 F42 (search for similar items in EconPapers)
Date: 1994-10
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Journal Article: Optimal target zones: How an exchange rate mechanism can improve upon discretion (1996) Downloads
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