Currency unions, pegged exchange rates and target zone models

Abstract

In this chapter we discuss the operation of exchange rate regimes which contrast with the paradigm of a free float. In particular, we discuss research which has been done on exchange rate target zones, in which the authorities undertake to maintain the exchange rate within a pre-agreed target range or zone. Even further along the line from a free float, we also consider the case where countries effectively irrevocably fix the nominal exchange rate between themselves by choosing to use the same currency and entering into a currency union. While the literature on target zones is relatively recent, dating from Williamson (1985), Williamson and Miller (1987) and Krugman (1991), that on currency unions has a much longer history, dating back to the seminal work of Mundell (1961), McKinnon (1963) and Kenen (1969). However, the general debate as to the desirability of fixed rather than flexible exchange rates has an even longer pedigree, dating back at least to Nurkse (1944) and Friedman (1953) and extending right up to the present day, and we provide a brief discussion of this in the next section, before turning our attention to currency unions and then target zones in the ensuing two sections. Fixed versus floating exchange rates The establishment of the International Monetary Fund at the Bretton Woods Conference of 1944 ushered in the post-war period of fixed exchange rates under what subsequently became known as the Bretton Woods system.