A framework for stabilizing the euro/yen/dollar triplet

Abstract

The current debate on exchange rate regimes is shaped by the so-called inconsistency triangle. In this paper I show that the discussion has overlooked a “third way” which combines capital mobility with monetary policy autonomy, and an exchange rate path determined by interest rate differentials. My scheme relies on interventions that are always carried out by the central bank with the strong currency, and a full sterilization of interventions with the instrument of a deposit facility. Thus the G3 central banks could set a band for their bilateral exchange rates with the floor and the ceiling defended by the respective strong central bank. As exchange rates bands are adjusted according to short-term interest rate differentials, there are no sterilization costs for the intervening central bank. Over the medium and long run interest rates are mainly determined by inflation differentials. Thus, the exchange rate band would follow a PPP path.