WEEK 7 - Economic Models of Fixed Exchange Rates: Target Zones Flashcards
Some historical arrangements of Target Zones
=>May 1995 Poland has adopted a crawling band of 7% on either side of the
central parity which is devalued at a constant monthly rate
=>Jan 1998 Russia replaced crawling exchange rate band with fixed band within rouble was allowed to float against the US$
=> Monetary arrangements for these ‘pre-ins’ dubbed ERM2 resemble old ERM
What is a Target Zone?
A range of permitted exchange-rate variation between upper and lower exchange-rate bands that a central bank defends by selling or purchasing foreign exchange reserves.
What does Krugman argue about Target Zones/Bands?
=>Exchange rates behave within a band like
flexible rates until they hit the edge of the band.
=>When they hit the bands, the regime switches to a fixed exchange rate.
Why might Krugman’s interpretation be wrong?
=>Since the existence of the bands constrains the future behaviour of the exchange rate.
=> agents are forward-looking this should affect behaviour of the exchange
rate in band.
=>Expectations formation is therefore a crucial aspect of determination of
target zone rates.
What is the exchange rate at any point given by?
st = mt + vt + αE (ds/dt)
Where: s = log of exchange rate m = log of money supply v = Velocity Shocks Last term expected change in exchange rate]
Can be rewritten as:
s = f + αE(ds/dt)
Where f = m + v
How is the velocity term denoted?
dv = σdz
Where:
dz = innovation in random walk process (Brownian process)
σ = variance of the innovation
How does intervention work in the base line model?
- > Monetary policy thought to be passive -> MS only altered if above S upper bar (sell foreign exchange) or below s down bar (buy foreign exchange)
- > Called marginal intervention
Why does the model predict foreign exchange intervention take place at the bands?
-> Assumed bands credible
=> Plays role in econ agent expectations
What does the graphical representation of the S Curve mean?
SEE GRAPH IN NOTES
If intervention at margin, then exchange rate moves like an S -> Since econ agents will know when intervention will occur
- Top half expected change in exchange rate negative, while bottom half is positive
- Existence of band has stabilising effect on exchange rate
What is the Honeymoon effect noted by Svensson?
Exchange rates follow bands even without monetary intervention due to credible bands
What does the defence of the S curve model explain?
SEE GRAPH IN NOTES
If band moves to 2 then rather than break band, you see shift to 3 (credible bands) -> Where intervention brings to 4
What are the implications of the basic target zone model?
- exchange rates and interest rates
2. their relationship with the fundamentals under target zone arrangements.
What are the assumption of the basic target zone model?
- Perfect Credibility
2. Characterisation of official intervention as marginal, which tested individually
Why did the basic target zone model fail?
- perfect credibility does not seem a reasonable assumption given history of ERM and realignments
- large interest rate differentials observed immediately before some of the realignments can be interpreted as evidence that investors demanded very high interest rates as a compensation for the anticipated devaluation of the currency.
- that central banks only
use marginal interventions, is also strongly rejected
What does Svensson remark when asked about the failure of the model?
“the great tragedy of science-the slaying of a beautiful hypothesis by an
ugly fact”
