Target Zones Flashcards
What’s a target zone?
A managed exchange rate system where a currency’s value is allowed to fluctuate within a predefined band, to allow flexibility but prevent extreme fluctuations
What did Krugman (1991) say?
Exchange rates behave within a fixed band like flexible rates until they hit the edge, then changes to a fixed ER. Expectations of future intervention influence the behaviour of ERs within the band
What’s a baseline target zone model?
St=mt+vt+infinityE[ds/dt] vt= velocity shocks. Upper band is ś and lower is ș. If ER lies within money supply remains unchanged. Exchange rate described by s curve. Any foreign exchange intervention takes place at the bands, where it buys or sells currency to prevent the breach of the target zone. Assumed Bands are credible. In top half expected change in ER is - while bottom half is +. When near boundaries the CB dampen volatility. Is called marginal intervention. The ER is influenced by fundamentals like money supply, interest rates, inflation differentials and speculative forces. Honeymoon effect- ER becomes less volatile near the boundaries without frequent intervention as traders anticipate ER will stabilise.
Failures of basic model?
Perfect credibility and characterisation of official interventions as marginal both are unrealistic. Perfect credibility is not a reasonable assumption as commitment within a target zone may be unrealistic e.g. European ERM CB not very willing to defend their currencies such as BOE in 1992 which lead to withdrawal from ERM. Intervention ineffective against large scale speculative attacks, exceeded CB capacity. Realignments were anticipated. Overall basic model is rejected. Also fails to capture speculative dynamics. Exchange rates can drift significantly. Oversimplification of the model limits its real world applicability to real world ER dynamics. Lastly it assumes a static environment where zones remain fixed over time, but in real world it often requires adjustment to econ conditions.
What are the modifications to the model?
Incorporating intramarginal intervention. Reduced smooth pasting conditions. If approaching near the edge authorities already known to be intervening, authorities will have intervened usually well before then. Straight line instead of a curve. Implies a honeymoon effect still, and reduction in expected volatility, due to intramarginal intervention, mitigating risk of markets doubting CB ability to defend the zone. Maintains confidence in the system. It helps smooth fluctuations in middle of the zone, reducing reliance on honeymoon effect. Also reduces profitability of speculative attacks through stabilising ER before boundaries.
Why is target zone an S curve
In middle ER is more sensitive to changes because CB less likely to intervene. Market forces determine ER in middle. Near edges CB Intervention becomes stronger, reducing ER sensitivity to fundamentals. So near boundaries it flattens, less volatile.
Policy Implications of s curve?
Reduced intervention costs if target zone is credible. S curve effect diminishes if credibility is undermined.
Broad vs narrow bounds?
Broad: greater flexibility, reduced need for intervention to use foreign exchange reserves. Harder for speculators to profit. Greater short term volatility, harming trade and investment. Possible weaker policy signal, reducing credibility.
Narrow: Clearer signal to markets about CB commitment to stability, reduces uncertainty. Force policymakers to maintain consistent and stable macro policies. May require frequent intervention, depleting reserves and risk of failure during speculative attacks. Reduced ability to absorb external shocks, leading to misalignments.
Examples of target zones?
Bretton woods system could fluctuate +/- 1%. For most of 1980s French franc was restricted also to a band of 2.25%. EMS crisis “Black Wednesday” British pound and Lira were attacked by speculators such as George Soros. UK and Italy exited ERM when they could no longer defend lower bounds of their target zone. Limited capacity of CB to defend boundaries when fundamentals diverged significantly.
Asian crisis 1997 Hong Kong Dollar Peg- fixed rate between HKD and USD with narrow bands. HKD under speculative pressure as regional currencies devalued. Its proactive intramarginal interventions like liquidity injections helped reduce volatility and support financial stability. Marginal intervention alone wouldn’t have been enough, as the interventions did not address the systemic risk.
