Optimal target zones and currency realignments

Chan-Woo Jeong, Purdue University

Abstract

This dissertation deals with both theoretical and empirical issues in the target zone literature. Two main problems arise in the theoretical target-zone literature, costless intervention and narrow positive focus. In chapter 3, we develop a simple static model to address these problems. The variances of price and output are obtained under the assumptions of marginal intervention and perfect credibility. The model shows a tradeoff between output stability and price stability in choosing the band width. The variance of price increases and the variance of output decreases with the band width. An optimal band width is obtained when the objective of the central bank is to minimize the sum of the variances of price and output. In that case the target-zone regime is found to be better than either free floating or fixed exchange rates. We carry out simple empirical tests for countries in the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) and other countries in the Organization for Economic Cooperation and Development (OECD) to test the predictions of the model. For the variance of price, the results are consistent with the prediction. The estimates of output variability, however, show mixed results. There are many factors outside the model which affect output other than the exchange rate and money supply, such as productivity and real wages, and these may have dominated the effects of exchange-rate band widths. In chapter 4, realignment expectations relative to Germany are calculated for six ERM countries in order to analyze an issue of mean reversion in the recent empirical target zone literature. Unlike earlier work we find no mean reversion to the central parity except for the Netherlands. The negative relationship between the expected rate of depreciation within the band and the departure of the exchange rate from the central parity is not sufficient to have mean reversion toward central parity as asserted by Svensson (1993) and others. The exchange rate which satisfies a condition for zero expected rate of depreciation within the band usually lies well above the central parity. Further, when observations at realignments are included in the estimation, the negative relationship becomes weaker, or in some cases disappears. This casts further doubt about mean reversion in the EMS.

Degree

Ph.D.

Advisors

Carlson, Purdue University.

Subject Area

Finance

COinS